Question

One year ago, your company purchased a machine used in manufacturing for $110,000. 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 $45,000 per year for the next 10 years. The current machine is expected to produce EBITDA of $21,000 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 42%, 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? The NPV of replacement is $ . (Round to the nearest dollar.) Should your company replace its year-old machine? O A. No, because the only time a machine should be replaced is when it stops working completely. OB. Yes, because a new machine will always be an improvement for the company. O C. Yes, because there is a profit from replacing the machine. OD. No, because there is a loss from replacing the machine.

Answer 1

Here, Cost of New Machinery = $ 160,000.

CCA Rate = 40%

Salvage Value = Nil

EBIDTA = $ 45,000

Life of Machine = 10 Years

Company's Tax Rate = 42%

Market Value of Current (Old) Machine = $ 50,000

Opporutnity Cost of Capital = 10%

Now, Step -1 : Calculation of Depreciation for 10 Years

Cost of New Machinery = $ 160,000

CCA Rate = 40%

Depreciation Amount = Opening Depreciated Value * CCA Rate

So, Calculation is as follows:

25 Calculation of Depreciation Opening Depreciated Value Depreciation Amount Closing Depreciated Value 1 5 160,000 S 64,000S 96,000 96,000S 38,4005 57,600 35 57,600S 23,0405 34,560 4 5 34,560 S 13,8245 20,736 5 S 20,736 S 8,2945 12,442 12,4425 4,977 S 7,465 7 S 7,465 S 2,986 S 4,479 4,479 S 1,7925 2,687 2,687 S 1,075 S 1,612 10 S 1,612 S 6455 967 6 S

Step - 2: Calculation of Present Value of Cash Inflow

Cash Inflow for the Year = EBITDA-Interest-Depreciation-Amortization =EBT

= EBT-(EBT*Tax Rate) =EAT

= EAT+Depreciation+Amortization

Here, Opportunity Cost of Capital = 10%

So, To convert Cash Inflow of each year into Present Value of Cash Inflow, Cash Inflow for each year should be multiplied by the Present Value Factor (PVF) @ 10%.

Present Value Factor = 1/ (1+r)^n , where: r = Opportunity Cost of Capital, n=number of the year

So, PVF @ 10% for 10 Years are as follows:

_ Years PVF @ 10% 11 __ 9 10 0.909 0.826 0.751 0.683 0.621 0.568 0.564 0.513 0.467 0.424 0.386

Now, we can calculate the Present Value of Cash Flow as under:

Years EBITDA Depreciation Amount EBT 1 $ 45,000S 64,000 S 25 45,000 $ 38,400 S 3 $ 45,000 S 23,040S 4 $ 45,000S 13,824S 5 S 45,000 $ 8,2945 6 $ 45,000S 4,977 S 7 S 45,000 $ 2,986 S 8 $ 45,000S 1,792S 9 $ 45,000 5 1,075 S 10 S 45,000 S 645 S Calculation of Present Value of Cash Inflow Tax Amount EAT Depreciation Amount Cash Inflow PVF @10% Present Value of Cash Inflow (19,000) S - S - S 64,000$ 64,000 0.9095 58,182 6,600S 2,772S 3,828S 38,400S 42,228 0.826 S 34,899 21,960S 9 ,223 S 12,737S 23,040 S 35,777 0.751 S 26,880 31,176 S 13,094S 18,0825 13,824 S 31,906 0.683 S 21,792 36,7065 15,416S 21,289S 8,2945 29,584 0.621 5 18,369 40,023 S 16,810S 23,2145 4,977S 28,190 0.564 S 15,913 42,014 S 17,646 S 24,368 S 2,986 S 27,354 0.513 5 14,037 43,208 S 18,148S 25,061 S 1,792 S 26,852 0.467 S 12,527 43,925 S 18,449 S 25,477 S 1,0755 26,551 0.424 5 11,260 44,355 S 18,629 S 25,726 S 645 S 26,371 0.386 S 10,167 Present Value of Cash Inflows 224,026

Step - 3: Calculation of Present Value of Cash Outflow:

Present Value of Cash Outflow = Cost of New Machinery-Market Value of Old Machinery

= $ 160,000-$50,000

= $110,000.

Step-4: Calculation of NPV of Replacement:

NPV of Replacement = Present Value of Cash Inflow - Present Value of Cash Outflow

= $224,026 - $110,000

= $ 114,026.

So, Yes, the company should replace the machine because

C. There is a profit from replacing the machine. The amount of profit is $ 114,026.

The following arguments are not correct:

A. The only time machine should be replaced is when it stops working because it will lead to the temporary shutdown of the production process until the new machine arrives.

B. Because the new machine will always be an improvement for the company is relevant when the new machine is not identical to the old machine and it is the requirement of the hour to shift to the new machine to gain competitive advantage/remain competitive in the market.

D. As there is a clear cut profit of $ 114,026 in case of replacement, the argument " No, Because there is a loss from replacing the machine." is incorrect.