Question

6. In 2018, a certain manufacturing company has some existing semi-automated production equipment which they are considering replacing. This equipment has a present and a book valth orsimen ive years tromnw eny a Me) espense and other relaltor the new equipment are S12 100 five years Based on an market value of S58,000 and a book value of $35,000. It has five more years of straight-line depreciation available (if kept) of $7,000 per year, at which time its BV would be zero. The estimated market value of the equipment five years from now (in year 0 dollars) is $18,100. The market value escalation rate on this type of equipment has been averaging 3.3% per year. The total annual operating and maintenance (O & M) expense and other related expenses are averaging $27,300 per year New automated replacement equipment would be leased. Estimated O & M and related company expenses for the new equipment are $12,100 per year. The annual leasing costs would be $23.800. The MARR (after-tax including inflation component) is 696, the effective tax rate is 25%, and the study period is five years. Based on an after-tax, AS analysis, should the new equipment be leased? Use the IRR method. The actual IRR on the incremental cash flows is 96 (Round to one decimal place ) The challenger should be (1) (1) O rejected O accepted

Answer 1

All financials below are in $.

Calculation 1

At t = 0, Market value of old equipment, MV = 58,000; it's book value, BV = $ 35,000

Hence, gain on sale= G = MV - BV = 58,000 - 35,000 = 23,000

Tax rate, T = 25%

Hence, tax on gain on sale= G x T = 23,000 x 25% = 5,750

Hence, post tax salvage value, S1 = MV - tax on gain on sale = 58,000 - 5,750 = 52,250

Calculation 2

At t = 5 years from now,

Market value of old equipment, MV₅ = 18,000 x (1 + 3.3%)⁵ = 21,172.60 ; it's book value, BV₅ = 0

Hence, gain on sale= G₅ = MV₅ - BV₅ = 21,172.60 - 0 = 21,172.60

Tax rate, T = 25%

Hence, tax on gain on sale= G₅ x T = 21,172.60 x 25% = 5,293.15

Hence, post tax salvage value, S2 = MV₅ - tax on gain on sale = 21,172.60 - 5,293.15 = 15,879.45

Please see the table below now. The cell highlighted in yellow contains the final answer. The adjacent cell highlighted in blue contains the excel formula used to calculate the IRR.

107 Year Linkage Post tax salavage value of old machine if it 108 sold now S1 (See calculation 1 52,250 Post tax salavage value of old machine S2 (See 109 foregone 110 111 Leasing cost of new machine 112 0&M cost of new machine 113 O&M cost of old machine saved 114 Depreciation of old machine foregone 115 Total pre tax costs 116 Total post tax costs 117 Less depreciation of old machine 118 Incremental operating cash flows 119 120 Incremental cash flows 121 IRR calculation 2) (15,879) (12,100) 2 27,300 27,300 27,300 0007000 7000 7000 700 27,300 27,300 (1,600) (7,000) (8,200) (8,200) D 35000/5 1,600)(1,600)(1,600 1,200) (1,200)(1,200) (7,00이 (7,00 (7,000)| 8,200) (8,200) (8,200) 1,200 (7,000) :Ex(1-25%) (8,200) H=S1 + S2 + G 52250 (8,200)(8,200)(8,200)(24,079) 2.4%l:RR(C120:H120)

Actual IRR = 2.4%

As IRR < MARR, the new equipment should be rejected. We should continue with the old machine only.