Question

One year? ago, your company purchased a machine used in manufacturing for $ 100 comma 000. You have learned that a new machine is available that offers many advantages and you can purchase it for $ 150 comma 000 today. It will be depreciated on a? straight-line basis over 10 years and has no salvage value. You expect that the new machine will produce a gross margin? (revenues minus operating expenses other than? depreciation) of $ 40 comma 000 per year for the next 10 years. The current machine is expected to produce a gross margin of $ 21 comma 000 per year. The current machine is being depreciated on a? straight-line basis over a useful life of 11? years, and has no salvage? value, so depreciation expense for the current machine is $ 9 comma 091 per year. The market value today of the current machine is $ 60 comma 000. Your? company's tax rate is 42 %?, and the opportunity cost of capital for this type of equipment is 11 %. Should your company replace its? year-old machine?

Answer 1

So for taking the decision , we could calculate the NPV of the new machine using differential approach

1) Increase in gross margin :-

(40,000-21,000) = 19, 000

Present value of above = 19,000 * [(1÷1.11)^10]

= 111,895

2) present value of tax savings on additional depreciation :-

Current depreciation = 9091

New depreciation = 150,0001÷10 = 15000

Difference = 5909

Tax savings = 5909 * 42% = 2481.78

Present value = 2481.78 * [(1÷1.11)^10]

= 14,616

3) sale of old machine = 60,000 inflow

4) Tax savings on loss of sale of old machine :

WDV of machine on the date of sale = 100,000 - 9,091

90,909

sale value = 60000

loss = 30909

Tax savings = 30909 * 42%

= 12982

5) outflow for new machine = 150,000

Therefore, net inflow = 49,493

Hence, company should replace its old machine