Question

St. Johns River Shipyard's welding machine is 15 years old, fully depreciated, and has no salvage value. However, even though it is old, it is still functional as originally designed and can be used for quite a while longer. The new welder will cost $81,500 and have an estimated life of 8 years with no salvage value. The new welder will be much more efficient, however, and this enhanced efficiency will increase earnings before depreciation from $26,000 to $52,000 per year. The new machine will be depreciated over its 5-year MACRS recovery period, so the applicable depreciation rates are 20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76%. The applicable corporate tax rate is 40%, and the firm's WACC is 13%. Should the old welder be replaced by the new one?

Old welder (Should or Should Not) be replaced.

What is the NPV of the project? Round your answer to the nearest cent.

Answer 1

Depreciation = Cost of welder x Depreciation rate

Depreciation Tax shield

Year	Depreciation (a)	Depreciation Tax shield (a x 40%)
1	$81500 x 20% = $16300	$6520
2	$81500 x 32% = $26080	$10432
3	$81500 x 19.20% = $15648	$6259.20
4	$81500 x 11.52% = $9388.80	$3755.52
5	$81500 x 11.52% = $9388.80	$3755.52
6	$81500 x 5.76% = $4694.40	$1877.76

Incremental Earnings before depreciation = $52000 - $26000 = $26000

Present value of Cash Inflows

Year 1 2 3 4 5 6 7-8 Incremental Earnings before depreciation net of tax [$26000 x (1 - 0.40) ] $15600 $15600 $15600 $15600 $15600 $15600 $15600 Add: Depreciation Tax shield $6520 $10432 $6259.20 $3755.52 $3755.52 $1877.76 Cash Inflows $22120 $26032 $21859.20 $19355.52 $19355.52 $17477.76 $15600 PVIF@13% 0.88495575221 0.78314668337 0.69305016227 0.61331872767 0.54275993599 0.48031852742 0.80122050543 Present Value of Cash inflows $19575.22 $20386.87 $15149.52 $11871.10 $10505.41 $8394.89 $12499.04

NPV = Total Present value of Cash Inflows - Cost of welder = $98,382.05 - $81500 = $16,882.05 [ Their might be some rounding off difference, you can try $16882.04 or $16882.06 ]

Since, NPV is positive, the welder should be replaced.