Question

Replacement Analysis

St. Johns River Shipyards' welding machine is 15 years old, fully depreciated, and has no salvage value. However, even though it is old, it is still functional as originally designed and can be used for quite a while longer. The new welder will cost $81,500 and have an estimated life of 8 years with no salvage value. The new welder will be much more efficient, however, and this enhanced efficiency will increase earnings before depreciation from $29,000 to $58,000 per year. The new machine will be depreciated over its 5-year MACRS recovery period, so the applicable depreciation rates are 20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76%. The applicable corporate tax rate is 40%, and the project cost of capital is 15%. Should the old welder be replaced by the new one?

Old welder _________________ be replaced.

What is the NPV of the project? Do not round intermediate calculations. Round your answer to the nearest cent.
$ ________

Answer 1

The cash flows of the replacement are

Year	Initial cost	Increase in earnings	Tax shield	NetCash flow
0	-81500			-81500
1		17400	6520	23920
2		17400	10432	27832
3		17400	6259.2	23659.2
4		17400	3755.52	21155.52
5		17400	3755.52	21155.52
6		17400	1877.76	19277.76
7		17400		17400
8		17400		17400

Increase in earnings = Increase in earnings before depreciation*(1-Tax)

Tax shield = Depreciation*Tax

NPV = $19078.77

Hence the old welder should be replaced by the new one since the NPV is positive.