Question

A division of Raytheon owns a 5-year-old turret lathe used to manufacture fabricated metal products that was purchased for $96,000 and now has a financial reporting (non-tax) book value of $24,000. It has been depreciated for tax purposes as MACRS-GDS 7-year property. It has a current market value of $18,000. The expected decline in market value is $3,000 per year from this point forward to a minimum of $3,000. O&M costs are $8,000 per year. Additional capability is needed. If the old lathe is kept, that new capability will be contracted out for $13,000, assumed payable at the end of each year. A new turret lathe has the increased capability to fulfill all needs, replacing the existing turret lathe and requiring no outside contracting. It can be purchased for $65,000 and will have an expected life of 8 years. Its market value is expected to be $65,000(0.7^t) at the end of year t. Annual O&M costs are expected to equal $10,000. If the after-tax MARR is 9 percent, the tax rate is 40 percent, and the planning horizon is 8 years, determine whether to keep and use a contractor or to sell and buy new.

Answer 1

Step I. Net cash outflow (assumed at current time) [Present values of cost]:

1. (Book value of old turret lathe - market value of old turret lathe) × Tax Rate = Tax payable/savings from sale

= (24000 – 18000) × 0.4 = 6000 × 0.40

= 2,400

1. Cost of new system - [Tax payable/savings from sale + Market value of old lathe]

Net cash outflow            =65,000 – (2400+18000) = $44,600

Step II. Estimated change in cash flows per year if replacement decision is implemented

Change in cash flow = [(saving in Additional capability cost -Change in depreciation- additional operating costs)] (1-tax rate) + Change in depreciation

                        Change in depreciation           = (65000/8) - (24000/8)

                                                                        =8125-3000

                                                                        =5125

Therefore, Change in cash flow          = (13000-5125-2000)*0.7+ 5125

                                                             = 4,112.5 +5125

                                                             = $9,237.5

Step III. Present value of benefits = Present value of yearly cash flows + Present value of estimated salvage of new system

Present value of estimated salvage of new system            = 65,000*(0.7^8) – [{3000*(1-tax)}]

                                                                                                          =3747-1800

                                                                                                          =1,947

= 9237.5 PVIFA (9%, 8) + 1,947 PVIF (9%, 8)

= 9237.5 *5.535+ 1947*0.502

= 51129.56+ 977.13

= $52,106.7

Step IV. Net present value = Present value of benefits - Present value of costs

= 52,106.7- 44,600

= $7,506.70

Therefore, as the replacement has positive NPV, the old lathe should be replaced.