Question

1. Assume a firm is considering replacing a machine that will increase EBITDA from $20,000 to $51,000 per year. The new machine will cost $100,000 and has a life of 8 years. The firm’s tax rate is 40%, and the cost of capital is 12%. The straight-line depreciation method will be used for tax purposes.
2. 1. Assume that the old machine has a book value of $40,000 and still has a useful life of 8 years, but can be sold today for a salvage value of $15,000. Further assume that the new machine will have a salvage value of $12,000. Should the replacement be made?

Answer 1

OLD MACHINE NEW MACHINE

WDV/Cost 40000 100000

Salvage value 15000 12000

useful life remaining 8 yrs 8yrs

Depreciation 5000 11000((100000-12000)/8)

cap loss old machine 25000 -

tax benefit of loss 10000 -

INITIAL INVESTMENT=100000(cost new machine)-15000(salvage value)-10000(tax benefit of loss)

=75000

Subsequent cash inflows

additional EBITDA 31000

less:additional dep 6000

EBT 25000

Tax 10000

EAT 15000

Add;Dep 6000  

Annaual cash inflow 21000

DAF @12%,8yr 4.968

PV annual cashflow 104328   

Terminal Cash Flows

new machine salvage value 12000

DF @12%,8yr 0.404

PV 4848

NPV of replacement decision=PV annual cash flows+PV terminal value-Initial investment

NPV of Replacement Decision=104328+4848-75000=24480

NPV is positive so machine should be replaced