Question

Zankel Incorp is considering replacing its old machine with a new machine. The cost of a new machine is RM 300,000 with a useful life of 4 years. The machine has an estimated salvage value of RM 45,000. The cost of installing this new machine will be RM 20,000. In the initial period, RM 125,000 in net working capital is required and to be recovered at the ending life of the machine. The company was using the present machine for 4 years and it has a remaining useful life of 2 years. The machine was bought at RM 200,000 and has a salvage value of RM 20,000. Currently, the machine can be sold at RM 90,000 and normally the company adopts straight- line method as a depreciation strategy. The new machine is expected to result in changes as follows:

• Increase in annual sales by RM 80,000.

• Reduction in annual defect cost by RM 6,000.

• Increase in annual operating cost by RM20,000

If corporate tax is 30%, the capital gain tax rate is 15%, and the required rate of return is 10%, determine:

a) Determine the net initial cash outlay

b) Determine the net annual cash flows

c) Determine the net terminal cash flows

d) Determine the net present value for the new machine

e) What is the replacement decision for the company?

Answer 1

a) net initial cash outlay = (cost of new machine + installation cost) - (sale value of old machine - tax on sale value of old machine) + net working capital investment

tax on salvage value of old machine = (salvage value of old machine - remaining book value of old machine)*capital gains tax rate

the old machine has remaining useful life of 2 years and original life is 6 (4+2) years.

depreciation per year = (cost of old machine - salvage value)/life of machine = (200,000 - 20,000)/6 = 180,000/6 = 30,000

Total depreciation applied in 4 years = 30,000*4 = 120,000

remaining book value of old machine = 200,000 - 120,000 = 80,000

tax on sale value of old machine = (90,000 - 80,000)*15% = 10,000*15% = 1,500‬

net initial cash outlay = (300,000 + 20,000) - (90,000 - 1,500) + 125,000 = 320,000 - 88,500 + 125,000 = 356,500‬

initial cash outlay is shown as a negative value for cash outflow. so initial cash outlay is -356,500.

b) net annual cash flows = [(Increase in annual sales + Reduction in annual defect cost - Increase in annual operating cost - Depreciation on new machine + Depreciation on old machine )*(1-corporate tax rate)] + Depreciation on new machine - Depreciation on old machine

Depreciation = (cost of new machine + installation cost - salvage value)/life of machine = (300,000 + 20,000 - 45,000)/4 = 275,000‬/4 = 68,750‬

net annual cash flows = [(80,000 + 6,000 - 20,000 - 68,750 + 30,000)*(1-0.30)] + 68,750 - 30,000 = (27,250‬‬*0.70) + 68,750 - 30,000 = 19,075‬‬ + 68,750 - 30,000 = 57,825‬

c) net terminal cash flows = (salvage value of new machine - tax on salvage value + recovery of net working capital)

tax on salvage value of new machine = (salvage value of new machine - remaining book value of new machine)*capital gains tax rate

remaining book value of new machine = cost of new machine - depreciation for 4 years = 320,000 - 68,750*4 = 320,000 - 275,000 = 45,000

tax on salvage value of new machine = (45,000 - 45,000)*15% = 0

net terminal cash flows = (45,000 - 0 + 125,000) = 170,000‬

d) & e) NPV = sum of present value of incremental cash flows - initial cash outlay

sum of present value of incremental cash flows = year 1 net annual cash flow/(1+required rate of return) + year 2 net annual cash flow/(1+required rate of return)².... + year 4 net annual cash flow/(1+required rate of return)⁴

company should not purchase the new machine as NPV is -$44,181.29. negative NPV means purchase of new machine will make losses in the project.

	Years	0	1	2	3	4	Total
	Cost of new machine	-320,000					-320,000
	net working capital	-125,000					-125,000
	Annual sales	0	80,000	80,000	80,000	80,000	320,000
Add:	Reduction in defect cost	0	6,000	6,000	6,000	6,000	24,000
Less:	increase in operating cost	0	20,000	20,000	20,000	20,000	80,000
Less:	New Depreciation	0	68,750	68,750	68,750	68,750	275,000
Add:	Old Depreciation	0	30,000	30,000	0	0	60,000
	Before-tax income	0	27,250	27,250	-2,750	-2,750	49,000
Less:	Taxes @30%	0	8,175	8,175	-825	-825	14,700
	After-tax income	0	19,075	19,075	-1,925	-1,925	34,300
Plus:	New Depreciation	0	68,750	68,750	68,750	68,750	275,000
Less:	Old Depreciation	0	30,000	30,000	0	0	60,000
Plus:	Salvage value	90,000	0	0	0	0	90,000
Less:	Tax on Salvage value	1,500	0	0	0	0	1,500
Plus:	Recapture of NWC	0	0	0	0	125,000	125,000
Plus:	Salvage value new machine	0	0	0	0	45,000	45,000
Less:	Tax on Salvage value new machine	0	0	0	0	0	0
	Total cash flows	-356,500	57,825	57,825	66,825	236,825	62,800
	NPV	-44,181.29

Calculations