Question

Pilot plus Pens is deciding when to replace its old machine. The old machine’s current salvage value is $2 million. Its current book value is $1 million. If not sold, the old machine will require maintenance costs of $400,000 at the end of the year, for the next five years. Depreciation on the old machine is $200,000 per year. At the end of five years, the old machine will have salvage value of $200,000 and a book value of $0. A replacement machine costs $3 million now and requires maintenance costs of $500,000 at the end of each year during its economic life of five years. At the end of five years, the new machine will have a salvage value of $500,000. It will be fully depreciated by the straight-line method. In five years, a replacement machine will cost $3,500,000. Pilot will need to purchase this machine regardless of what the choice it makes today. The corporate tax rate is 34% and the appropriate discount rate is 12%. The company is assumed to earn sufficient revenues to generate tax shields from depreciation. Should Pilot Plus replace the old machine now or at the end of five years?

Answer 1

Date	Cash Flow	Tax saved on Depreciation	PV @ 12%	PV of CF
01-01-16
31-12-16	-400000	68000	0.892857143	-296429
31-12-17	-400000	68000	0.797193878	-264668
31-12-18	-400000	68000	0.711780248	-236311
31-12-19	-400000	68000	0.635518078	-210992
31-12-20	-400000	68000	0.567426856	-188386
			Pv of Cash Outflow	-1196786
			Less: Salvage Value	113485.4
			Total PV of Cash Flow	-1083300
Machine New
Date	Cash Flow	Tax saved on Depreciation	PV @ 12%	PV of CF
01-01-16	-1000000			-1000000
31-12-16	-500000	204000	0.892857143	-264286
31-12-17	-500000	204000	0.797193878	-235969
31-12-18	-500000	204000	0.711780248	-210687
31-12-19	-500000	204000	0.635518078	-188113
31-12-20	-500000	204000	0.567426856	-167958
			Pv of Cash Outflow	-2067014
			Less: Salvage Value	283713.4
			Total PV of Cash Flow	-1783300
PV of Future Cash Outflow (if old machine is used for 5 years)
		35ooooo-(200000*5)*.567428	1418567.139

Total PV of Cash Outflow if old machine is continued
		-1083300.328	-1418567	=	-2501867

Looking at the NPV of cash outflow in both the scenrios it is advisable for the company to purchase a new machine right away,