Question

Question 1

Subang Folding Box Berhad is considering purchasing a new gluing machine. The gluing machine costs RM50,000 and requires installation costs of RM2,500. This outlay would be partially offset by the sale of an existing gluer.

The existing gluer originally cost RM30,000 and is four years old. It is being depreciated under straight line method and can currently be sold for RM15,000. The existing gluer has a remaining useful life of two years. If held until year six, the existing machine's market value would be zero.

Over its five-year life, the new machine should reduce operating costs (excluding depreciation) by RM17,000 per year. Training costs of employees who will operate the new machine will be a one-time cost of RM5,000 which should be included in the initial outlay. The new machine will be depreciated under straight line method and estimated disposal value is RM10,000. The firm has a 12 percent cost of capital and a 40 percent tax on ordinary income and capital gains.

Required:

1. Calculate the initial cash outflow associated with replacing the older machine with the new one?                                                                                        

2. Calculate the net present value if the company decided to but the new gluing machine?

                                                                                                       

3. Should Subang Folding Box Berhad replace the old machine?

           

Answer 1

Existing machine original cost. = $30,000

Useful life. = 4+2 = 6 years

Market value 4th year. = 15,000

Calculation of book value on 4th year of existing machine

Depreciation per year = 30,000/6 = 5,000

Book value = 30,000 - (5,000*4) = 10,000

Capital gain on sale = $15,000 - $10,000 = 5,000

Tax on capital gain = 5,000*40% = 2,000

After tax income from sale of machine =

15,000 - 2,000 = 13,000

Initial outlay = 50,000 + 2,500 + 5,000 - 13,000 = 44,500

(b)

We calculate the net cash flow table as below:

	Year (n )	0	1	2	3	4	5
A	Initial Outlay	Rm 44,500
B	Post tax savings on operating costs		$ 10,200	$ 10,200	$ 10,200	$ 10,200	$ 10,200
C	Depreciation (old machine)		5,000	5 000
D	Depreciation (New machine)		8,500	8,500	8,500	8,500	8,500
E	Incremental Depreciation (New - Old)		3,500	3,500	8,500	8,500	8,500
F	Tax shield on incremental depreciation @40%		1,400	1,400	3,400	3,400	3,400
	Salvage Value of machine						10,000
G	Net cash flow (CF)	-44,500	11,600	11,600	13,600	13,600	23,600
	PVIF @12%	1.0000	0.8929	0.7972	0.7118	0.6355	0.5674
	NPV	-44,500	10,357	9,247	9,680	8,643	13,391

Net present value (Sum) = 6,818

Net present value of replacement is postive , hence , the company should replace the old machine with new machine.