Question

A Machine purchased six years ago for Rs 150,000 has been depreciated to a book value of Rs 90,000. It originally has projected life of 15 years and zero salvage value. A new machine will cost Rs 350,000 and result in reduction of operating cost of Rs 40,000 in first year which will increase @8% for next eight years. The older machine could be sold for Rs 135,000. The cost of capital is 10%. The new machine will be depreciated on a straight line basis over nine year life with Rs 35,000 salvage value. The company normal tax rate is 40% whereas capital gain tax rate is 10%. Should we replace the old machine?

Answer 1

Here,

Old Machine Book Value = 90,000

Selling price of old machine = 135000

So profit = 135000 - 90000 = 45000

So Tax = 10% *45000 = 4500

So value realised = 135000 - 4500 = 130500

Now New Machine in place of old machine will have,

initial cost = 350000

Since 130500 will be realised by selling old

We will have initial cost = 350000 - 130500 = 219500

Yearly savings = 40000 increasing by 8% for next 8 years

Depreciation = Straight line with 35000 salvage value

So yearly depreciation = (350000 - 35000)/9 = 35000

Cost of Capital =10%

So Yearly cash flow we have as,

Year End	Year 6	Year 7	Year 8	Year 9	Year 10	Year 11	Year 12	Year 13	Year 14	Year 15
Initial Cost	-219500
Yearly Revenue savings		40000	43200	46656	50388.48	54419.56	58773.12	63474.97	68552.97	74037.21
Depreciation		35000	35000	35000	35000	35000	35000	35000	35000	35000
PBT		5000	8200	11656	15388.48	19419.56	23773.12	28474.97	33552.97	39037.21
Tax		2000	3280	4662.4	6155.392	7767.823	9509.249	11389.99	13421.19	15614.88
PAT		3000	4920	6993.6	9233.088	11651.74	14263.87	17084.98	20131.78	23422.33
Salvage Value										35000
Depreciation add back		35000	35000	35000	35000	35000	35000	35000	35000	35000
Cash flow		38000	39920	41993.6	44233.09	46651.74	49263.87	52084.98	55131.78	93422.33

So Present Value,

NPV = -219500 + 38000/(1+.1)+39920 / ((1+.1)^(2)) + 41993.09 / ((1+.1)^(3)) + 44233.09 / ((1+.1)^(4)) + 46651.74 / ((1+.1)^(5)) + 49263.87 / ((1+.1)^(6)) + 52084.98 / ((1+.1)^(7)) + 55131.78 / ((1+.1)^(8)) + 93422.33 / ((1+.1)^(9))

NPV = 58642.03

Since NPV is positiveso machine should be replaced