Question

Pilot Plus Pens is deciding when to replace its old machine. The machine's current salvage value is $2.25 million. Its current book value is $1.45 million. If not sold, the old machine will require maintenance costs of $850,000 at the end of the year for the next five years. Depreciation on the old machine is $290,000 per year. At the end of five years, it will have a salvage value of $125,000 and a book value of $0. A replacement machine costs $4.35 million now and requires maintenance costs of $335,000 at the end of each year during its economic life of five years. At the end of the five years, the new machine will have a salvage value of $805,000. It will be fully depreciated by the straight-line method. In five years a replacement machine will cost $3,250,000. The company will need to purchase this machine regardless of what choice it makes today. The corporate tax rate is 40 percent and the appropriate discount rate is 8 percent. The company is assumed to earn sufficient revenues to generate tax shields from depreciation. Calculate the NPV for the new and old machines.

Answer 1

Old Machine			Replacement Machine
Book vale	1450000		Book vale	4350000
Depriciation P.A	290000		Depriciation P.A	870000
Salvage value after 5 years	125000		Salvage value after 5 years	125000
Book Value at the end of 5 years	0		Book Value at the end of 5 years	0
Maintenance Cost	850000		Maintenance Cost	335000
Current Salvage Value	2250000		Salvage value after 5 years	805000
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Purchase Price of New Machine	-43,50,000.00
Salvage value of the Old Machine	22,50,000.00
Tax on Salvage Value	14,80,000.00
Upfront Cost	-35,80,000.00
Increamental Cash Flows
Savings in Maintenance Cost		515000	515000	515000	515000	515000
Depricaition Tax Sheild		232000	232000	232000	232000	232000
Post Tax Salvage Value at the end of 5 Years						483000
Net Cash Flows	-35,80,000.00	747000	747000	747000	747000	1230000
NPV @8%	-2,48,818.44

The calculation of the same is below for your perusal.

The New Machine that needs to be purchased after 5 years is indifferent and will not impact our calculations.

Since the NPV is Negative the new machine should not purchased.