Question

Builtrite A is considering replacing a 10 year old machine that originally cost $30,000, has a current book value of $10,000 with five years of expected life left. The machine is being depreciated over its 15 year life down to a terminal value of $0. Currently, this machine has an expected salvage value of $15,000. The replacement machine that Builtrite is considering would cost $80,000 and be depreciated down to $0 over its five year expected life. At the end of five years the new machine is expected to have a salvage value of $40,000. Builtrite expects to save $30,000 (before depreciation and taxes) annually due to the new machine efficiencies. Assume straight-line depreciation, a 34% marginal tax rate and an expected return of 20%.

Should Builtrite A purchase this machine?

Answer 1

Time line		0	1	2	3	4	5
Proceeds from sale of existing asset	=selling price* ( 1 -tax rate)	9900
Tax shield on existing asset book value	=Book value * tax rate	3400
Cost of new machine		-80000
=Initial Investment outlay		-66700
Savings			30000	30000	30000	30000	30000
-Depreciation	Cost of equipment/no. of years		-16000	-16000	-16000	-16000	-16000
=Pretax cash flows			14000	14000	14000	14000	14000
-taxes	=(Pretax cash flows)*(1-tax)		9240	9240	9240	9240	9240
+Depreciation			16000	16000	16000	16000	16000
=after tax operating cash flow			25240	25240	25240	25240	25240
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)						26400
+Tax shield on salvage book value	=Salvage value * tax rate						0
=Terminal year after tax cash flows							26400
Total Cash flow for the period		-66700	25240	25240	25240	25240	51640
Discount factor=	(1+discount rate)^corresponding period	1	1.2	1.44	1.728	2.0736	2.48832
Discounted CF=	Cashflow/discount factor	-66700	21033.33	17527.78	14606.481	12172.068	20752.958
NPV=	Sum of discounted CF=	19392.61831

Accept project as NPV is positive