Question

Pilot Plus Pens is deciding when to replace its old machine. The machine's current salvage value is $2.21 million. Its current book value is $1.41 million. If not sold, the old machine will require maintenance costs of $846,000 at the end of the year for the next five years. Depreciation on the old machine is $282,000 per year. At the end of five years, it will have a salvage value of $121,000 and a book value of $0. A replacement machine costs $4.31 million now and requires maintenance costs of $331,000 at the end of each year during its economic life of five years. At the end of the five years, the new machine will have a salvage value of $801,000. It will be fully depreciated by the straight-line method. In five years a replacement machine will cost $3,210,000. The company will need to purchase this machine regardless of what choice it makes today. The corporate tax rate is 34 percent and the appropriate discount rate is 9 percent. The company is assumed to earn sufficient revenues to generate tax shields from depreciation.

  

Calculate the NPV for the new and old machines.

Answer 1

Calulation of NPV of Old Machine
Year	0	1	2	3	4	5	NPV
Opportunity cost of outflow (after Tax)	-1,938,000
Maintainece Cost		-846,000	-846,000	-846,000	-846,000	-846,000
Depreciation		-282,000	-282,000	-282,000	-282,000	-282,000
Sale/Gain of Salvage						121,000
Total Cost		-1,128,000	-1,128,000	-1,128,000	-1,128,000	-1,007,000
Tax Saving		383,520	383,520	383,520	383,520	342,380
Outflow after Tax		-744,480	-744,480	-744,480	-744,480	-664,620
Add: Depreciation		282,000	282,000	282,000	282,000	282,000
Net Outflow	-1,938,000	-462,480	-462,480	-462,480	-462,480	-382,620
Disc. Rate=1/(1+9%)^n	1.00000	0.91743	0.84168	0.77218	0.70843	0.64993
Disc. Net Outflow	-1,938,000	-424,294	-389,260	-357,119	-327,632	-248,677	-3,684,982
Calulation of NPV of New Machine
Year	0	1	2	3	4	5	NPV
Initial Outflow
New Machine Cost	-4,310,000
Salvage Value						801,000
Tax on Salvage Value						-272,340
Capital (Outflow)/Inflow	-4,310,000	-	-	-	-	528,660
Maintainece Cost		-331,000	-331,000	-331,000	-331,000	-331,000
Depreciation		-862,000	-862,000	-862,000	-862,000	-862,000
Total Cost		-1,193,000	-1,193,000	-1,193,000	-1,193,000	-1,193,000
Tax Saving		405,620	405,620	405,620	405,620	405,620
Outflow after Tax		-787,380	-787,380	-787,380	-787,380	-787,380
Add: Depreciation		862,000	862,000	862,000	862,000	862,000
Net operating Inflow/(Outflow)		74,620	74,620	74,620	74,620	74,620
Net Free Inflow/(outflow)	-4,310,000	74,620	74,620	74,620	74,620	603,280
Disc. Rate=1/(1+9%)^n	1.00000	0.91743	0.84168	0.77218	0.70843	0.64993
Disc. Net Inflow	-4,310,000	68,459	62,806	57,620	52,863	392,091	-3,676,161
Decision: Since NPV of the outflow in case of new machine as compare to old machine is lesser, so it is better to buy new machine
Note:a replacement machine after five will cost $3,210,000 is irrelavent
Calculation of Inflow due to sale of Old Machine at year zero
Sales Value		2,210,000
Book Value=(282000*5)		1,410,000
Gain		800,000
Tax on Gain		272,000
Net realisation after tax		1,938,000