Question

The Darlington Equipment Company purchased a machine 5 years ago at a cost of $90,000. The machine had an expected life of 10 years at the time of purchase, and it is being depreciated by the straight-line method by $9,000 per year. If the machine is not replaced, it can be sold for $5,000 at the end of its useful life. A new machine can be purchased for $180,000, including installation costs. During its 5-year life, it will reduce cash operating expenses by $40,000 per year. Sales are not expected to change. At the end of its useful life, the machine is estimated to be worthless. The new machine is eligible for 100% bonus depreciation at the time of purchase. The old machine can be sold today for $55,000. The firm's tax rate is 25%. The appropriate WACC is 9%. a. If the new machine is purchased, what is the amount of the initial cash flow at Year 0 after bonus depreciation is considered? Cash outflow should be indicated by a minus sign. Round your answer to the nearest dollar. $ b. What are the incremental cash flows that will occur at the end of Years 1 through 5? Round your answers to the nearest dollar. Year 1 Year 2 Year 3 Year 4 Year 5 $ $ $ c. What is the NPV of this project? Do not round intermediate calculations. Round your answer to the nearest cent. $ Should Darlington replace the old machine? -Select- Screenshot

Answer 1

Answer :

(a) Cash Outflow at year 0 after bonus depreciation is considered

Cash Outflow = Initial Purchase of Equipment - Gain on sale of old equipment (net of taxes) - Tax Shield on Bonus Depreciation

Calculation of Gain on sale of old equipment (net of taxes) :

Gain on sale = Salvage value - Book Value

= 55000 - [90000 - (9000 * 5)]

= 55000 - 45000

= 10000

Tax on gain on sale = 10000 * 25% = 2500

Gain on sale of old equipment (net of taxes) = Salvage value - Tax on gain on sale

= 55000 - 2500

= 52500   

Tax shiled due to bonus depreciation of 100% = Depreciation * Tax rate

= 180,000 * 25%

= 45000

Cash Outflow = 180000 - 52500 - 45000

= (-82,500)

  

(b.) Calculation of Incremental Cash Flows

Incremental Cash Flows = Annual Cash Flow * (1 - tax rate)

Incremental Cash Flows for year 1 = 40000 * (1 - 0.25)

= 30000

Incremental Cash Flows for year 2 = 40000 * (1 - 0.25)

= 30000

Incremental Cash Flows for year 3 = 40000 * (1 - 0.25)

= 30000

Incremental Cash Flows for year 4 = 40000 * (1 - 0.25)

= 30000

Incremental Cash Flows for year 5 = 40000 * (1 - 0.25)

= 30000

(c.) Calculation of NPV

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

= (Annual Cash Inflow * PVAF @ 9% for 5 years) - 82500

= (30000 * 3.8896512633) - 82500

= 116,689.537899 - 82500

= 34,189.54

Yes , the machine should be purchased as it has positive NPV.