Question

St. Johns River Shipyards is considering the replacement of an 8-year-old riveting machine with a new one that will increase earnings before depreciation from $24,000 to $46,000 per year. The new machine will cost $80,000; and it will have an estimated life of 8 years and no salvage value. The new machine will be depreciated over its 5-year MACRS recovery period, so the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. The applicable corporate tax rate is 40%, and the firm's WACC is 10%. The old machine has been fully depreciated and has no salvage value. Should the old riveting machine be replaced by the new one? Explain your answer. Show your calculation of the after-tax cash flows, a timeline with the after-tax cash flows, and calculate the NPV.

Answer 1

Formula	Year (n)	0	1	2	3	4	5	6	7	8
	Initial investment (II)	80000
Earnings from new equipment - current earnings	Incremental earnings (IE)		22000	22000	22000	22000	22000	22000	22000	22000
5-year MACRS	Depreciation rate ('r)		20.00%	32.00%	19.00%	12.00%	11.00%	6.00%
II*r	Depreciation (D)		16000	25600	15200	9600	8800	4800	0	0
IE*(1-Tax rate)+(D*Tax rate)	Operating cash flow (OCF)		19600	23440	19280	17040	16720	15120	13200	13200
OCF - II	Free cash flow (FCF)	-80000	19600	23440	19280	17040	16720	15120	13200	13200
1/(1+10%)^n	Discount factor @ 10%	1.000	0.909	0.826	0.751	0.683	0.621	0.564	0.513	0.467
FCF*Discount factor	PV of FCF	-80000	17818.18	19371.90	14485.35	11638.55	10381.80	8534.85	6773.69	6157.90
Sum of all PVs	NPV	15162.22

NPV of the replacement decision = 15,162.22. The equipment should be replaced as the NPV is positive. (Note: If exact 5-year MACRS rates are taken, then NPV = 15,165.36)