Question

Your company is using a computer where its original cost was $25,000. The machine is now 5 years old. Its current market value is $5,000. The computer is being depreciated over a 10 years life towards zero salvage value. Depreciation is on straight-line basis. The management is contemplating buying a new computer which will cost $ 50,000. The estimated salvage value is $1,000. Expected saving from the new computer is $3,000 a year. Depreciation is on straight-line basis over a 7 years life and the cost of capital is 10%. If the tax rate is 50%, should your company replace the computer?

Answer 1

Company should replace the machine. Calculations below.

Old method	Amount	Calculation
Tax saving on depreciation	1250	2500*0.5	(Cost - Salvage value)/no of years*tax rate
Per year savings	1250
New method	Amount	Calculation	Notes
Tax saving on depreciation	3500	(50000-49000)/7*0.5	(Cost - Salvage value)/no of years*tax rate
Cost of capital	-2500	50000*0.1*0.5	Cost * Cost of capital*tax rate
Savings from switching to new	1500	3000*0.5	Savings*Tax rate
Per year savings	2500
1st year income on sale of old machine	8750	5000+(12500-5000)*0.5	sale value+(Book value-Market value*tax rate)

1st year income on sale of old machine = Tax benefit is due to market value being less than book value. Its a book loss incurred 12500 is arrived at +25000/10*5 (Cost/no of years*no of years left)