Question

Canal Company is contemplating the purchase of a new leather sewing machine to replace the existing machine. The existing machine was purchased four years ago at an installed cost of $115,000; it was being depreciated under MACRS using a 5-year recovery period. The existing machine is expected to have a useful life of 5 more years. The new machine costs $203,000 and requires $8,000 in installation costs; it has a five-year useable life and would be depreciated under MACRS using 5-year recovery period. Canal can currently sell the existing machine for $52,000 without incurring any removal or cleanup costs. To support the increased business resulting from purchase of the new machine, accounts receivable would increase by $63,000, inventories by $12,000, and accounts payable by $72,000. At the end of 5 years, the existing machine is expected to have a market value of zero; the new machine would be sold to net $66,000 after removal and cleanup costs and before taxes. The firm is subject to a 33% tax rate and a WACC of 13.36%. The estimated earnings before depreciation, interest, and taxes over the 5 years for both the new and the existing grinder are shown in the table. Earnings before interest, taxes, depreciation and amortization Year New Machine Existing Machine 1 $75,000 $36,000 2 $75,000 $33,000 3 $75,000 $30,000 4 $75,000 $27,000 5 $75,000 $24,000 Should Canal Company invest in the new machine? Solve the problem in Excel, showing your work and making sure you answer the above question.

Answer 1

If the company continued with the old machine which has been duly depreciated, then the current sale price of old price becomes its opportunity cost for NPV calculations, given as below:

Now we look at the NPV of replacing the old machine with the new machine:

• The initial cost will be reduced by the sale price of old machine
• The changes in working capital are considered permanent and will be = (63000+12000-72000) = 3000
• The taxes on profit of sale of old machine (since it is fully depreciated) at 33% * (52000-6624) = 14974.08 are assumed to be paid at end of Year 1 and not immediately in Year 0

As we see that the NPV of installing new machine is significantly higher than continuing with old one, we should install the new machine.