Question

We are trying to decide whether to replace the original machine with a new machine.

Original Machine: Initial cost = 1,000,000; Annual depreciation = 180,000; Purchased 2 years ago; Book Value = 640,000; Salvage today = 700,000; Salvage in 3 years = 150,000

New Machine: Initial cost = 600,000; 3-year life, straight-line depreciation; Salvage in 3 years = 100,000; Cost savings = 50,000/year

Required return = 10% and Tax rate = 40%

a. Should we replace the original machine with the new machine?

b. What are the consequences of selling the old machine today instead of in 5 years?

Answer 1

a) If New machine is bought

Realisation from sale of old machine = 700000 - tax on (700000 - 640000) = 700000 - 60000*0.4 = $676000

Incremental cost of buying new machine = $600000 - $676000 = -$76000 (negative cost i.e benefit)

Annual Depreciation of new machine = (600000-100000)/3 = 166,666.67

So, change in depreciation = 166666.67 - 180000 = -13333.33

Incremental annual cashflows

= (cost savings - change in depreciation)* (1-tax rate) + change in depreciation   

=(50000 -(-13333.33))*(1-0.4) +(-13333.33)

=24666.67

Book value of old machine after 3 years = 640000 - 3*180000 = 100000

After tax salvage value of old machine = 150000- (150000-100000)*0.4 = 130000

Incremental salvage value = 100000 - 130000 = -30000

So, NPV of changing the machine

= -(-76000)+24666.67/0.1*(1-1/1.1^3)+(-30000)/1.1^3 = $114802.91

As the NPV is positive, the old machine should be replaced with a new machine

b) Selling the old machine today would result in instant realisation of salvage value of $700000 rather than $150000 later. Further, the depreciation amount cant be used for tax benefit if machine is sold now. Lastly, the salvage value is not realised if machine is sold today.