Question

ABC company is considering replacing their old manual loading machine with an automatic loading machine. The manual machine cost $300000 three years ago, and is being depreciated over 10 years straight line depreciation, with no salvage value. If ABC replaces the manual machine, the new automatic machine will cost $4000000 and have a useful life of 10 years. This will also be depreciated on a straight line basis to zero. As a result of this new machine, there will be pretax savings of $130000 in labour costs and $25000 in other cash expenses annually. If the automatic machine is purchased, the old machine will immediately be sold at a price of $280000. The company has already spent $11500 researching costs associated with this decision. The company's tax rate is 40% and no inflation is expected. The company's cost of capital is 7%.

Required: Calculate the Net Present Value of this decision and state with supportive reason, whether or not your company should purchase the automatic machine.

Answer 1

Net Present value = Present value of cash inflow - present value of cash outflows

The researching costs already incurred are sunk costs and are not relevant for this decision

Written down value of old machine = 300,000*7/10 = 210,000

Selling Price = $280,000

Gain on Sale = $70,000

Tax = 70,000*40% = 28,000

Selling price after tax = 280,000-28,000 = $252,000

Annual Depreciation on new machine = 4,000,000/10 = $400,000

NPV = -4,000,000+252,000 + [(130,000+25,000- 400,000)(1-40%)+400,000]*PVAF(7%, 10 years)

= -3,748,000 + 253,000*7.02358

= -$1,971,033.87

Since, NPV is negative, the new machinery should not be purchased

Note: Please cross check the number of zeros in the purchase price of new machine. The solution is correct for the posted figure of $4,000,000