Question

Greensboro Company purchased a machine five years ago for $350,000. On its tax return, Greensboro depreciated the asset using the straight-line method to a zero salvage value over ten years. Now, this used machine could be sold for $120,000.

A new machine has recently become available that will cost $950,000 and last for five years. If purchased, the new machine will save $300,000 per year in before tax operating costs and be depreciated by the straight-line method over five years to a zero salvage value for income tax purposes..  

At the end of five years, Greensboro estimates the new machine could be sold for $50,000 while the old machine, if kept, would only sell for $18,000.

Greensboro requires a 15% after-tax rate of return and its relevant income tax rate is 30%.

1. Determine the net after-tax cash outlow at time zero (CF0) if Greensboro were to purchase the new machine and sell the (used) old machine.
2. Determine the incremental after-tax cash benefits at times 1 through 5 if Greensboro were to acquire the new machine and sell the old machine.
3. Determine that incremental after-tax cash flows at the projects end (time 5*) if Greensboro were to acquire the new machine rather than keep the old machine.
4. Should Greensboro acquire the new machine to replace the old machine?

No excel if possible

Answer 1

(a) Net after-tax cash outflow at time t = 0: -

(Purchase cost of new machine) - (Sales proceed from Old machine at time t = 0)*(1-tax rate)

On calculating, net after-tax cash outflow at time t = 0 is $581,000: -

(b) Note that depreciation costs per year for both old and new machines have been calculated using their book value, their salvage value, and years of depreciation. Given they follow a straight-line method: -

Depreciation cost per year (for Old machine) is $35,000: -

Depreciation cost per year (for New machine) is $190,000: -

Hence, every year the new machine helps in cost savings of $300,000, but incurs additional depreciation costs of $155,000. Net income payout (pre-tax) from the new machine can be calculated as: -

Net income payout (post-tax) from the new machine can be calculated as pre-tax income payout multiplied by (1-tax rate) is $101,500 : -

We add back the depreciation costs because they are not cash outflows.

Hence, the incremental after-tax cash benefits at times 1 through 5 if Greensboro were to acquire the new machine and sell the old machine is $256,500.

(c)

Net after-tax cash outflow at time t = 5*: -

(Proceeds from sale of new machine) - (Proceeds from sale of old machine)*(1-tax rate)

On calculating, net after-tax cash outflow at time t = 0 is $22,400: -

(d) Calculations are shown in the table attached.

Calculating NPV at 15% after-tax rate of return using the formulae:

NPV is $289,964.54. Given it is positive, old machine should be replaced.