Question

One year​ ago, your company purchased a machine used in manufacturing for $ 105 000. You have learned that a new machine is available that offers many​ advantages; you can purchase it for $ 155 000 today. It will be depreciated on a​ straight-line basis over ten years and has no salvage value. You expect that the new machine will produce a gross margin​ (revenues minus operating expenses other than​ depreciation) of $ 40 000 per year for the next ten years. The current machine is expected to produce a gross margin of $ 24 000 per year. The current machine is being depreciated on a​ straight-line basis over a useful life of 11​ years, and has no salvage​ value, so depreciation expense for the current machine is $ 9 545 per year. The market value today of the current machine is $ 65 000. Your​ company's tax rate is 42 %​, and the opportunity cost of capital for this type of equipment is 12 %. Should your company replace its​ year-old machine?

Answer 1

Solution:

Purchase price of Existing machine	a	$ 105,000
Depreciation per year	b	$ 9,545
Book value	c=a-b	$ 95,455
Market price of existing machine	d	$ 65,000
Capital loss	e=c-d	$ 30,455
Tax saving on capital loss	f=e*42%	$ 12,791.10
After tax Salvage value	g=d+f	$ 77,791.10
		Machine 1	Machine 2
Cash outflow at t0	z	-$ 77,791	-$ 1,55,000
Cash inflow per year	h	$ 24,000	$ 40,000
Depreciation per year	i	$ 9,545	$ 4,000
Cash inflow after depreciation	j=h-i	$ 14,455	$ 36,000
Cash flow after tax	k=j*68%	$ 9,829	$ 24,480
Add back depreciation	l=k+i	$ 19,374	$ 28,480
PVIFA @12%, 10 year	m	5.6502	5.6502
PV of Cash inflow of 10 years	n=l*m	$ 109,470	$ 160,918
NPV	n+z	$ 31,679	$ 5,918

As continuation of existing machine gives more NPV than replacing the same with new one, hence the existing machine should be continued.