Question

FinTronics currently uses an injection-molding machine that was purchased two years ago for $24,000. The machine is being depreciated on a straight-line basis to a zero salvage value and it has six years of remaining depreciable life (two years have already passed) and its current market value is $3,000. If FinTronics keeps the old machine it would have no salvage value in six years. FinTronics has been offered a replacement machine that has a cost of $24,000, an estimated useful life of six years, and an estimated salvage value of $800. This machine will be depreciated straight-line to a zero salvage value over six years. The new machine would permit an output expansion, so sales would rise by $1,000 per year. Even with the sales increase, its much greater efficiency would cause operating expenses to decline by $1,500 per year. The new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $500. All working capital will be recovered at the end of the project. FinTronics’ tax rate is 34 percent and its cost of capital is 15%. Should FinTronics replace the machine?

Answer 1

The incremental after tax cash flows and the NPV of the replacement are arrived at as shown below:
	0	1	2	3	4	5	6
Annual increase in sales		1000	1000	1000	1000	1000	1000
Annual savings in operating expenses		1500	1500	1500	1500	1500	1500
Incremental depreciation [24000/6-24000/8]		1000	1000	1000	1000	1000	1000
Incremental NOI		1500	1500	1500	1500	1500	1500
Tax at 34%		510	510	510	510	510	510
NOPAT		990	990	990	990	990	990
Add: Incremental depreciation		1000	1000	1000	1000	1000	1000
Incremental OCF		1990	1990	1990	1990	1990	1990
Capital expenditure:
Cost of new machine	24000
Salvage value of old machine	3000
Tax shield on loss on sale of old machine = (18000-3000)*34% =	5100
[Book value of old machine = 24000-3000*2 = 18000]
After tax salvage of new machine (800*66%)							528
Increase in NWC [2000-500]	1500						-1500
Annual after tax project cash flows	-17400	1990	1990	1990	1990	1990	4018
PVIF at 15% [PVIF = 1/1.15^n]	1	0.86957	0.75614	0.65752	0.57175	0.49718	0.43233
PV at 15%	-17400	1730	1505	1308	1138	989	1737
NPV	-8992
DECISION:
As the NPV of the replacement is negative, the replacement should not be made.