Question

One year ago, your company purchased a machine used in manufacturing for $120,000. You have learned that a new machine is available that offers many advantages and that you can purchase it for $160,000 today. The CCA rate applicable to both machines is 40%; neither machine will have any long-term salvage value. You expect that the new machine will produce earnings before interest, taxes, depreciation, and amortization (EBITDA) of $35,000 per year for the next ten years. The current machine is expected to produce EBITDA of $22,000 per year. All other expenses of the two machines are identical. The market value today of the current machine is $50,000. Your company's tax rate is 38%, and the opportunity cost of capital for this type of equipment is 10%. Should your company replace its year-old machine? What is the NPV of replacement??

What is the NPV of replacement?

Answer 1

Replacing the machine increases EBITDA by 35,000 – 22000 = 13,000

Depreciation expenses rises by $64,000 –$48,000 = $16,000. Therefore, FCF will increase by (13,000) × (1-0.38) + (0.38)(16,000) = $14,140 in years 1through 10

In year 0, the initial cost of the machine is $160,000. Because the current machine has a book value of $120,000, selling it for $50,000 generates a capital gain of 50,000 – 120,000 = –70,000. This loss produces tax savings of 0.38 × 70,000 = $26,600, so that the after-tax proceeds from the sales including this tax savings is $76,600. Thus, the FCF in year 0 from replacementis

-170,000 + 76,600 = -$93,400

NPV of replacement = –93,400 + 14,140 * (1 - (1 + 0.10)^-10)/0.10 = -$6515.82. There is a Loss from replacing the machine.