Question

One year ago, your company purchased a machine used in manufacturing for $105,000. You have learned that a new machine is available that offers many advantages and you can purchase it for $165,000 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 (revenues minus operating expenses other than depreciation) of $45,000 per year for the next 10 years. The current machine is expected to produce a gross margin of $23,000 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 $9,545 per year. The market value today of the current machine is $65,000. Your company's tax rate is 35%, and the opportunity cost of capital for this type of equipment is 10%.

a. The NPV of replacing the year-old machine is $______________ (Round to the nearest dollar.)

b. Should your company replace its year-old machine?

Answer 1

Initial Investment = Cost of new asset - Sale of old asset - Tax saving

                            = 165000 - 65000 - [105000-9545-65000]*35%

                           = $100000 - 10659

                           = $ 89,341

Salvage Value = 0

Deprecialtion on new Asset = 165000/10 = 16500 per year

Additional Cash Flow (Yearly) :

Additional Cash Inflow (45000-23000)    = 22,000

Less : -   Additional Depreciation (16500-9545)        =   6,955

               Profit Before Tax (PBT)                            = 15,045

Less : -                        Tax @ 35%                            =   5,266

              Profit After Tax (PAT)                                =   9,779

Add :         Additional Depreciation                            =   6955

              Net additional Cash Inflow                     = $16,734

Present value

Present Value of Cash inflow of 10 year = 16734 * PVFA_1-10

Where, PVFA_1-10 = Present value factor annuity for 10 years

So, Present Value of Cash inflow of 10 year = 16734 * [{1-(1.1)^-10}/0.1]

                                                                       = 16734 * 6.14457

                                                                        = 102823.23

      Present Value of Cash inflow of 10 year = $ 102,823 (Approximately)

So, Net Present value of Project = 102823-89341 = $13,482

a) So, NPV of replacing the old machine is $ 13,482.

b) Yes, Company should replace its old machine, because NPV is positive.