Question

*One year ago, your company purchased a machine used in manufacturing for $110 000. You have learned that a new machine is available that offers many advantages; you can purchase it for $150 000 today. It will be depreciated on a straight-line basis over 10 years and has no salvage value. You expect that the new machine will produce a gross margin (revenue minus operating expenses other than depreciation) of $40 000 per year for the next 10 years. The current machine is expected to produce a gross margin of $20 000 per year. The current machine is being depreciated on a straight-line basis over a useful life of 11 years, and has no salvage value, so depreciation expense for the current machine is $10 000 per year. The market value today of the current machine is $50 000. Your company’s tax rate is 30%, and the opportunity cost of capital for this type of equipment is 10%. Should your company replace its year-old machine?

when npv is worked out at the end, how would you determine if you should replace the machine or not?

Answer 1

If by replacing machine Incremental cost and incremental revenu has poitive NPV, then machine should be replaced.

[A]Present Value of Incremental Cost :

= Cost of new machine - sales proceeds of old machine

=150,000-50,000

=100,000

This is today's cost hence it is the present value of incremental cost

[A] Present Value of Incremental Revenue (Cashinflow) :

= (Increase in Gross Margin per Year + Tax savings on Incremental Depreciation per year)

= (20,000 + 5,000*30%)

= 21,500

Incremental Cash Inflow will be earned for 10 years. Hence, present value is required to be calculated as below:

Year	Cash Inflow	DF @ 10%	PV of Cash Inflow
1	21,500	0.91	19,545
2	21,500	0.83	17,769
3	21,500	0.75	16,153
4	21,500	0.68	14,685
5	21,500	0.62	13,350
6	21,500	0.56	12,136
7	21,500	0.51	11,033
8	21,500	0.47	10,030
9	21,500	0.42	9,118
10	21,500	0.39	8,289
Total PV of Cash Inflow			132,108

NPV = PV of Incremental cost - PV of Cash inflow

        = 132,108 - 100,000

        = 32,108

As incremental NPV is positive, decision of replacement of machine should be taken.