Question

Wonderland Pty Ltd is considering replacing an old illusion-generating machine in its magic-performing division with a state-of-the-art illusion-generating machine that would increase the sale revenues from $ 35,000 to $100,000. The new machine would cost the company $500,000 to purchase and has a life of 10 years. It also has an estimated salvage value of $50,000 at the end of its life.

The old machine was purchased 5 years ago at a cost of $200,000 and the accumulated depreciation shown in accounting records is $100,000. It has a remaining life of 5 years and as that time it will be worthless. However, the company can sell the old machine to other companies in the industry now for $120,000. Both the old machine and the new machine are depreciated using the straight-line method. The company has a tax rate of 30 percent and its required rate of return is 10 percent per annum.

Should the company replace the old machine now or later in five-year time? (Show all workings and state any assumptions that may be necessary).

Answer 1

Calculation of Net present value if Machine is replaced now
Step -1	Calculation of Net cash out flow
	Book value of old machine	$2,00,000
	Less:Accumulated depreciation	$1,00,000
	written down value of old system	$1,00,000
	Market value of old machine	$1,20,000
	Profit on sale ($120000-$100000)	$20,000
	Tax on profit @30%	$6,000
	Net sale proceed from old machine
	($120000-$6000)	$1,14,000
	Cost of new machine	$5,00,000
	Less:Net sale proceeds from old machine	$1,14,000
	Net cash outflow for new machine	$3,86,000

Step -2	Estimated change in cashflow if new machine is purchased
	Change in cash flow=(Change in sales (less) change in deprectaion) - Tax@30%+Change in depreciation
	Change in sales ($100000-$35000)	$65,000
	Change in depreciation                                                                                                                          ($500000-$50000)/10 year = 45000                                                                        Less: ( $200000/10 year)      = 20000	$25,000
	Therefor inflow before tax is (65000-25000)	$40,000
	Less:Tax @ 30% ($40000*30%)	$12,000
		$28,000
	Add:Change in depreciation (45000-20000)	$25,000
	Net change in cash inflow	$53,000

Step -3	Calculation of present value of change in cash inflow
	Net change in cash inflow	$53,000
	Annuity value of required rate of return for 5 years	3.791
	Prresent value of change in cash inflow($53000*3.791)	$2,00,923
Note:Life of old machine is only 5 years and hence change in cash inflow can be calculated for 5 years only.And for the rest 5 years cah inflows are calculated as follows

	Add:Present value of cash inflow for the rest 5 years
	Change in sales value	$100000
	Less:Depreciation ($500000-$50000)10 Years	$45,000
	Profit before tax	$55,000
	Less :Tax @30%	$16500
	Profit after tax	$38500
	Add:Depreciation	$45,000
	Net cash inflow	$83500
	Present value of annuity for the rest 5 years	2.354
	Present value of cash inflow($83500*2.354)	$1,96559
	Add:Present value of salvage value at the end of 10 th year
	Salvage value                                                                                         $50000
	PV factor at the end of 10 th year                                                     0.3855
	Present value of salvage value($50000*0.3855)	$19,275
	Total Present value of cash inflows ($200923+$196559+ $19275)	$416757

Step -4	Calculation of present value of change in cash inflow
	Total Present value of cash inflows	$416757
	Less:Net outflow of new machine	$3,86,000
	Net Present value $ (359084-386000)	$ 30757

Calculation of Net present value if Machine is replaced after 5 years

Step -1	Calculation of Net cash out flow
	Cost of new machine	$5,00,000
	Less:Net sale proceeds from old machine	NIL
	Net cash outflow for new machine	$5,00,000

Step -2	Estimated cashflow if new machine is purchased
	Cash inflow($100000)	$100000
	Less:Depreciation ($500000-$50000)/10years	$45,000
	Profit before tax	$55,000
	Less:Tax @ 30% ($55000*30%)	$16500
	Profit after tax	$38500
	Add:Depreciation	$45,000
	Net cash inflow	$83500

Step -3	Calculation of present value of cash inflow
	Net cash inflow	$83500
	Annuity value of required rate of return for 10 years	6.145
	Prresent value of change in cash inflow($59000*6.144)	$513108
	Add:Present value of salvage value at the end of 10 th year
	Salvage value                                                                                         $50000
	PV factor at the end of 10 th year 0.3855
	Present value of salvage value($50000*0.3855)	$19,275
	Total Present value of cash inflows ($513108+ $19275)	$532383

Step -4	Calculation of present value of change in cash inflow
	Total Present value of cash inflows	$532383
	Less:Net outflow of new machine	$5,00,000
	Net Present value $	32383

Net present value if replaced now	$ 30757
Net present value if replaced after 5 years	$32383

It is better to replace the machine after 5 years based on the NPV,as the NPV is higher than now