Question

The TP Company is looking to replace an existing machine with a new, more efficient version. TP feels the new will extend the production life by one year while increasing cash flows. The new machine will cost $150,000 today and have a 6 year production life.It will be depreciated as 5-year MARCS property with an estimated salvage value of $20,000 at the end of its production life. The project will also set aside $6,000 for working capital. The old machine had an estimated production life of seven years, had originally cost $75,000 and was being depreciated as 5-year straight-line. It is currently 2 years old and could be sold for $30,000 today. TP estimated that if they kept, they would sell it for $10,000 at the end of its production life. The new is estimated to produce cash revenue of $160,000 per year and have cash expenses of $67,500 per year (excluding depreciation and taxes) for its production life. TP has a 35% tax rate and requires a 15% return on this investment. Use NPV and determine if they should invest.

Answer 1

Old Machine book value

Book value = (purchase price)*remaining life/total life
= (75000)*3/5
= 45000

Time line		0	1	2	3	4	5	6
Proceeds from sale of existing asset	=selling price* ( 1 -tax rate)	19500
Tax shield on existing asset book value	=Book value * tax rate	15750
Cost of new machine		-150000
Initial working capital		-6000
=Initial Investment outlay		-120750
5 years MACR rate			20.00%	32.00%	19.20%	11.52%	11.52%	5.76%
Sales			160000	160000	160000	160000	160000	160000
Profits	Sales-variable cost		92500	92500	92500	92500	92500	92500
-Depreciation	=Cost of machine*MACR%		-30000	-48000	-28800	-17280	-17280	-8640
=Pretax cash flows			62500	44500	63700	75220	75220	83860
-taxes	=(Pretax cash flows)*(1-tax)		40625	28925	41405	48893	48893	54509
+Depreciation			30000	48000	28800	17280	17280	8640
=after tax operating cash flow			70625	76925	70205	66173	66173	63149
reversal of working capital								6000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)							13000
+Tax shield on salvage book value	=Salvage value * tax rate							0
=Terminal year after tax cash flows								19000
Total Cash flow for the period		-120750	70625	76925	70205	66173	66173	82149
Discount factor=	(1+discount rate)^corresponding period	1	1.15	1.3225	1.520875	1.7490063	2.0113572	2.3130608
Discounted CF=	Cashflow/discount factor	-120750	61413.04	58166.35	46160.927	37834.628	32899.676	35515.28
NPV=	Sum of discounted CF=	151239.9055

Accept project as incremental NPV is positive