Question

Original Machine Initial cost = 1,000,000 Annual depreciation = 180,000 Purchased 2 years ago Book Value...

Original Machine

Initial cost = 1,000,000

Annual depreciation = 180,000

Purchased 2 years ago

Book Value = 640,000

Salvage today = 700,000

Salvage in 3 years = 150,000

•New Machine

Initial cost = 700,000

3-year life, straight-line depr

Salvage in 3 years = 100,000

Cost savings = 50,000/year

•Required return = 10%

•Tax rate = 40%

Should the company buy new machine?

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Homework Answers

Answer #1

a) If New machine is bought

Realisation from sale of old machine = 700000 - tax on (700000 - 640000) = 700000 - 60000*0.4 = $676000

Incremental cost of buying new machine = $700000 - $676000 = $24000 (expense)

Annual Depreciation of new machine = (700000-100000)/3 = 200000

So, change in depreciation = 200000 - 180000 = 20000

Incremental annual cashflows

= (cost savings - change in depreciation)* (1-tax rate) + change in depreciation   

=(50000 -(20000))*(1-0.4) +(20000)

=38000

Book value of old machine after 3 years = 640000 - 3*180000 = 100000

After tax salvage value of old machine = 150000- (150000-100000)*0.4 = 130000

Incremental salvage value = 100000 - 130000 = -30000

So, NPV of changing the machine

= -(24000)+38000/0.1*(1-1/1.1^3)+(-30000)/1.1^3

= -24000+94500-39930 = 30570

As the NPV is positive, the old machine should be replaced with a new machine

b) Selling the old machine today would result in instant realisation of salvage value of $700000 rather than $150000 later. Further, the depreciation amount cant be used for tax benefit if machine is sold now. Lastly, the salvage value is not realised if machine is sold today.

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