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?

please give steps in detail, do not use excel .

Answer 1

Given salvage value of old machine as $2 million and book value as $1 million. By retaining this machine Pilot Plus Pens is forgoing an opportunity of $2 million not $1 million. Therefore we can assume retaining old machines cost $2 million.

Maintenance and derpreciation on this machine are $400,000 and $200,000 respectively. These costs are reducing income by $600,000 yearly. Hence, they provide tax savings of 0.34* $600,000 = $204,000. Which means effective cost of maintenance and depreciation is $600,000 - $204,000 = $396,000. Except, the final year where, salvage value is included as shown in the table below.

Maintenance	Depreciation	Salvage	Tax Savings	Effective Cost
$ 4,00,000.00	$ 2,00,000.00		$ 2,04,000.00	$   3,96,000.00
$ 4,00,000.00	$ 2,00,000.00		$ 2,04,000.00	$   3,96,000.00
$ 4,00,000.00	$ 2,00,000.00		$ 2,04,000.00	$   3,96,000.00
$ 4,00,000.00	$ 2,00,000.00		$ 2,04,000.00	$   3,96,000.00
$ 4,00,000.00	$ 2,00,000.00	$ 2,00,000.00	$ 1,36,000.00	$   2,64,000.00

Net Present Value of Effective Cost at 12% discount rate = $1,352,591

Opportunity cost of retaining old machine = $2 Million

Therefore, Net present value of old machine = $3,352,591

New machine Maintenance cost = $500,000

Salvage value of new machine = $500,000

Depreciation for new machine = ($3,000,000 - $500,000) / 5 = $500,000

Similar to old machine table below shown effective cost for new machine

Maintenance	Depreciation	Salvage	Tax Savings	Effective Cost
$ 5,00,000.00	$ 5,00,000.00		$ 3,40,000.00	$   6,60,000.00
$ 5,00,000.00	$ 5,00,000.00		$ 3,40,000.00	$   6,60,000.00
$ 5,00,000.00	$ 5,00,000.00		$ 3,40,000.00	$   6,60,000.00
$ 5,00,000.00	$ 5,00,000.00		$ 3,40,000.00	$   6,60,000.00
$ 5,00,000.00	$ 5,00,000.00	$ 5,00,000.00	$ 1,70,000.00	$   3,30,000.00

Net Present Value of Effective Cost at 12% discount rate = $2,191,901

Price of new machine = $3 Million

Therefore, Net present value of new machine = $5,191,901

As net present value of costs for new machine is higher than that of old machine it is better to retain old machine than buying new one.