Question

The leader of a large construction company is worried about the appearance of a new excavator on the market. In fact, this The device is clearly superior to the one the company bought 1 year ago. As a result, the market value of the excavator used by the company has dropped from $ 400,000 last year to $ 40,000 this year. In 10 years, it will only be worth $ 5,000. The new excavator costs only $ 650,000 and is expected to increase operating profits by $ 70,000 per year. It has a life of 10 years and is estimated to be worth recovery at $ 105,000. If the tax rate is maintained at 35%, the rate capital cost allowance (CCA) for both excavators is 25% and that the minimum return required is 13%, what should this manager do?

Answer 1

In order to decide what decision should be made, we will first calculate NPV under both Alternatives.

a) Alternative 1, If the manager buy new machine

	Year 0	Year1	Year 2	....	Year 9	Year 10
Profit		70,000	70,000		70,000	70,000
Increase in CCA		62,500	62,500		62,500	62,500
Net Profit before tax		7,500	7,500		7,500	7,500
-: Tax		2,625	2,625		2,625	2,625
Net Profit after Tax		4,875	4,875		4,875	4,875
Add :CCA		62,500	62,500		62,500	62,500
Net Cash Flow		67,375	67,375		67,375	67,375
Capital Investment	(650,000)
Sale of Old Machine	40,000
Sale of new machine						105,000

NPV =-650,000+40,000+4,875* Present value factor for 10 years at 13% +105,000*

=-610,000+67,375*5.426+105,000*.295

=-610,000+3,65,576.75+30,975

= -213,448.25

b) Alternative 2, If the manager does not buy new machine

=5,000*.295

=$1,475

As the NPV in case 2 is positive it is advised not to buy new machine