Question

One year​ ago, your company purchased a machine used in manufacturing for $110,000. You have learned that a new machine is available that offers many​ advantages; you can purchase it for $150,000 today. It will be depreciated on a​straight-line basis over ten​ years, after which it has no salvage value. You expect that the new machine will contribute EBITDA​ (earnings before​ interest, taxes,​ depreciation, and​ amortization) of $40,000 per year for the next ten years. The current machine is expected to produce EBITDA of $20,000 per year. The current machine is being depreciated on a​straight-line basis over a useful life of 11​ years, after which it will have no salvage​ value, so depreciation expense for the current machine is $10,000 per year. All other expenses of the two machines are identical. The market value today of the current machine is $50,000.Your​ company's tax rate is 45%​, and the opportunity cost of capital for this type of equipment is 10%. Is it profitable to replace the​ year-old machine?

Answer 1

We need to calculate Present value of incremental cash flow if new machine id purchased. If it is positive then it is profitable to replace the old machine.

First we will calculate Incremental cash outflow.

Next we will calculate Incremental annual cash inflow

Now we will calculate present value of 10 years Incremental cash inflow

Present value of incremental cash inflow is $81,419.93

Now we will calculate net incremental cash flow

=Incremental cash Inflow-Incremental cash outflow

=81,419.93-77,500

=$3,919.93

As net incremental cash flow is positive it is profitable to replace old machine.