Question

. Topsider Inc. is considering the purchase of a new leather-cutting machine to replace an existing machine that has a book value of $3,000 and can be sold for $1,500. The old machine is being depreciated on a straight-line basis, and its estimated salvage value 3 years from now is zero. The new machine will reduce costs (before taxes) by $7,000 per year. The new machine has a 3-year life, it costs $14,000, and it can be sold for an expected $2,000 at the end of the third year. The new machine would be depreciated over its 3-year life using the MACRS method. Assuming a 40 percent tax rate and a required rate of return of 16 percent, find the new machine's NPV.
A. -$2,822
B. $1,658
C. $4,560
D. $15,374
E. $9,821

Answer 1

Calculation of Incremental Depreciation
Year	Depreciation Rates	New Machine Depreciation	Old Machine Depreciation	Incremental Depreciation
A	B	C = $14,000 * B	D = 3000/3	E = C-D
1	33.33%	4666.2	1000	3666.2
2	44.45%	6223	1000	5223
3	14.81%	2073.4	1000	1073.4
Calculation of Initial Outlay in Year 0
Tax on sale of Old machine = (Sale value - Book value) * tax rate
		= ($1500 - $3000) * 40%
		= -$600
After tax sale value of old machine = Sale value + tax credit due to loss
		= $1500 + $600 = $2,100
Net Initial Investment in year 0 = after tax salve value of old machine - cost of new machine
		= $2,100 - $14,000
		= -$11,900

Calculation of NPV of the project
Particulars	0	1	2	3
Initial Investment
Net Investment (A)	-11900
Operating Cash Flows
Reduction in cots (B)		7000	7000	7000
Incremental Depreciaiton (C )		3666.2	5223	1073.4
Profit Before Tax (D = B-C)		3333.8	1777	5926.6
Tax @40% (E = D*40%)		1333.52	710.8	2370.64
Profit After Tax (F = D-E)		2000.28	1066.2	3555.96
Add back Incremental Depreciaiton (G = C)		3666.2	5223	1073.4
Net Operating Cash Flows (H = F+G)		5666.48	6289.2	4629.36
Terminal Value
Salvage Value (I)				2000
Unclaimed Depreciation (J) $14,000 * 7.41%				1037.4
Profit on sale (K = I-J)				962.6
Tax @40% (L = K*40%)				385.04
After tax Salvage Value (M = I-L)				1614.96
Total Cash Flows (N = A+H+M)	-11900	5666.48	6289.2	6244.32
Discount Factor @16% (O) 1/(1+16%)^n n=0,1,2,3	1	0.862069	0.743163	0.640658
Discounted Cash Flows (P = N*O)	-11900	4884.897	4673.9	4000.472
NPV of the Project	1659.268
Therefore, new Machine NPV is $1,659
Option B is correct