Question

DISCUSS QUESTION #4 The Oxford Equipment Company purchased a machine 5 years ago at a cost of $85,000. The machines expected life is 10 years and is being depreciated by the straight-line method at a rate of $8,500 per year. If the machine is kept, it can be sold for $15,000 at the end of its expected life. A new machine can be purchased for $170,000. It has an expected life of 5 years and will reduce cash operating expenses by $40,000 per year. Sales will not change. At the end of its useful life, the machines estimated value is zero. The new machine is eligible for 100% bonus depreciation at the time of purchase. The old machine can be sold today for $55,000. The tax rate is 25% and the appropriate WACC is 9%

	0	1	2	3	4	5
Cash Flow Per Year:
PV @16%
NPV=
Should the machine be purchased?

Answer 1

*The Oxford Equipment Company purchased a machine 5 years ago at a cost of $85,000.

*The machines expected life is 10 years and is being depreciated by the straight-line method at a rate of $8,500 per year

* If the machine is kept, it can be sold for $15,000 at the end of its expected life

*A new machine can be purchased for $170,000.

*It has an expected life of 5 years and

*will reduce cash operating expenses by $40,000 per year

*The new machine is eligible for 100% bonus depreciation at the time of purchase.

*The old machine can be sold today for $55,000.

* The tax rate is 25% and the appropriate WACC is 9%

>>Incremental dep. Tax shield = Incre. Depreciation * tax rate

Incre. Depreciation = new depreciation ( fully depreciated at the time of purchase, so 0 - old depreciation ( 8500 ) = - 8500

Incremental dep. Tax shield = - 8500 * 25% = - 2125

>> initial investment =

New equip = 170000 ( outflow)

Bonus depreciation tax shield = (100%) = 170000 * 25% = 42500 (inflow)

Net initial investment = 170000 - 42500 = 127500

>>Tax on sale of old equip.

Market value = 55000

Book value at this time= 5 year are depreciated so remaining five year dep. Is its book value = 5 * 8500 = 42500

Taxable gain = 55000 - 42500 = 12500

Tax on Gain of proceeds of old equip. = 12500 * 255 = 3125

>>Opportunity cost at end from sale of old equip.

Market value = 15000

Book value = 0 ( fully depreciated )

Taxable gain = 15000

Tax on gain = 15000 * 25% = 3750

Net proceeds from old equip. If it exist = 15000 - 3750 = 11250 (opportunity cost)

Years	0	1	2	3	4	5
Annual savings		40000	40000	40000	40000	40000
tax exp@25%		(10000)	(10000)	(10000)	(10000)	(10000)
Incremental dep. Taxshild		(2125)	(2125)	(2125)	(2125)	(2125)
Initial investment	(127500)
Sale of old equip.	55000
Tax on sale of old equip.	(3125)
Opportunity cost at end from sale of old equip.						(11250)

After tax cash flow	(75625)	32125	32125	32125	32125	20875
PV of $1 factor @16%	1	0.862	0.743	0.6406	0.552	0.476
PV of cash flow	(75625)	27693.97	23874.11	20581.13	17742.35	9938.86

NPV = PV of cash flow - initial investment

NPV@16% = 99830.41 - 75625 = 24205.41