Question

Calligraphy Pens is deciding when to replace its old machine. The machine's current salvage value is $2,700,000. Its current book value is $1,625,000. If not sold, the old machine will require maintenance costs of $675,000 at the end of the year for the next five years. Depreciation on the old machine is $325,000 per year. At the end of five years, it will have a salvage value of $120,000 and a book value of $0. A replacement machine costs $4,300,000 now and requires maintenance costs of $345,000 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 $710,000. It will be fully depreciated by the straight-line method. In five years, a replacement machine will cost $3,300,000. The company will need to purchase this machine regardless of what choice it makes today. The corporate tax rate is 23 percent and the appropriate discount rate is 7 percent. The company is assumed to earn sufficient revenues to generate tax shields from depreciation. Calculate the NPV for the new and old machines. (Do not round intermediate calculations and enter your answers in dollars, not millions, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer 1

1)	NPV OF OLD MACHINE:
a)	Initial outlay:
	Current sale value (opportunity cost)	$      27,00,000
	Current book value	$      16,25,000
	Gain if sold	$      10,75,000
	Tax on gain at 23%	$         2,47,250
	After tax salvage value = 2700000-247250 =	$      24,52,750
b)	PV of after tax annual maintenance costs = 675000*(1-23%)*(1.07^5-1)/(0.07*1.07^5) =	$      21,31,078
c)	PV of depreciation tax shield = 325000*23%*(1.07^5-1)/(0.07*1.07^5) =	$         3,06,490
d)	PV of after tax salvage value at EOY 5 = 120000*(1-23%)/1.07^5 =	$            65,880
	NPV of old machine = -2452750-2131075+306490+65880 =	$     -42,11,455
2)	NPV OF NEW MACHINE:
a)	Initial outlay	$      43,00,000
b)	PV of after tax annual maintenance costs = 345000*(1-23%)*(1.07^5-1)/(0.07*1.07^5) =	$      10,89,217
c)	PV of depreciation tax shield = 860000*23%*(1.07^5-1)/(0.07*1.07^5) =	$         8,11,019
d)	PV of after tax salvage value at EOY 5 = 710000*(1-23%)/1.07^5 =	$         3,89,790
	NPV of new machine = -4300000-1089217+811019+389790 =	$     -41,88,408