Question

One year​ ago, your company purchased a machine used in manufacturing for $ 120,000. You have learned that a new machine is available that offers many​ advantages; you can purchase it for $ 140,000 today. It will be depreciated on a​ straight-line basis over ten​ years, after which it has no salvage value. You expect that the new machine will contribute EBITDA​ (earnings before​ interest, taxes,​ depreciation, and​ amortization) of $ 55,000 per year for the next ten years. The current machine is expected to produce EBITDA of $ 23,000 per year. The current machine is being depreciated on a​ straight-line basis over a useful life of 11​ years, after which it will have no salvage​ value, so depreciation expense for the current machine is $ 10,909 per year. All other expenses of the two machines are identical. The market value today of the current machine is $ 50,000. Your​ company's tax rate is 40 %​, and the opportunity cost of capital for this type of equipment is 12 %. Is it profitable to replace the​ year-old machine?

Answer 1

Tax shield due to Loss on sale of Existing machine
Particulars	$
Current Market value of the existing machine	50,000
Book value of the machine after the expiry of one year ($1,20,000- $ 10,909)	1,09,091
Loss due to sale	-59,091
Tax shield on Loss (@ 40%)	-23,636

Computation of Additional depreciation on New Machine
Particulars	New machine ($)	Old Machine ($)
Cost of the Machine	1,40,000	1,20,000
Useful life (years)- Straight line basis	10	11
Depreciation per year	14,000	10,909
	A	B

Additional depreciation on account of New Machine (C= A-B)	3,091
Extra Tax savings of depreciation on account of New machine @ 40% (C *40%)	1,236
Present value of tax savings for next 10 years [cost of capital being 12% (i.e.) $ 1,236* Present Value Annuity Factor for 10 years- 5.65)	6,985

Computation of Incremental EBITA
Particulars	New machine ($)	Old Machine ($)
EBITA (i)	55,000	23,000
Number of years (ii)	10	11
Present Value Annuity Factor for cost of capital @ 12% (iii)	5.65	5.94
Present value of potential earnings [(i) * (iii)]	3,10,750	1,36,574
	A	B

Incremental Present value of earnings on account of New Machine (C= A-B)	1,74,176
Tax rate	40%
After Tax Present value of incremental earnings for the next 10 years	1,04,506

Computation of Net Present Value- If the New Machine is acquired
Particulars	$
Incremental EBIT	1,04,506
Cash Inflow on sale of existing machine	50,000
Tax shield on capital loss	23,636
Tax savings on extra depreciation	6,985
Total Cash Inflows	1,85,127
Less: Investment in New Machinery	1,40,000
Net Present Value	45,127

Recommendation:

Since Net Present Value (NPV) of the proposal is positive, the company is advised to replace the old machine.