Question

XYZ Company’s machine was purchased 5 years ago for $55,000. It had an expected life of 10 years when it was bought, and its remaining depreciation is $5,500 per year for each year of its remaining life and can be sold for $20,000 at the end of its useful life. A new machine can be purchased for $120,000, including the installation costs. During its 5-year life, it will reduce cash operating expenses by $30,000 per year. Sales revenue will not be affected. At the end of its useful life, the machine is estimated to be sold at $10,000. We will use MARCS depreciation, and the machine will be depreciated over its 5-year property class life. The old machine can be sold today for $35,000.

*The tax rate is 35%

*WACC is 16%

a) what is the amount of the initial cash flow at Year 0 if the new machine is purchased?

b)Calculate the after-tax salvage value of the new machine at the end of the project?

c)Calculate the incremental cash flows that will occur at the end of years 1-5?

*Use excel cell reference for the questions for the above questions

Answer 1

a)	Cost of the new machine		$   1,20,000
	Sale value of the old machine	$      35,000
	Book value = 5500*5 =	$      27,500
	Gain on sale	$        7,500
	Tax on gain at 35%	$        2,625
	After tax sale value of old machine = 35000-2625 =		$       32,375
	Initial cash flow at Year 0		$       87,625
b)		0	1	2	3	4	5
	Savings in operating expenses		$       30,000	$     30,000	$      30,000	$     30,000	$      30,000
	Incremental depreciation:
	Depreciation on new machine [MACRS 5 Year]		$       24,000	$     38,400	$      23,040	$     13,824	$      13,824	6912
	Depreciation on the old machine		$         5,500	$       5,500	$         5,500	$        5,500	$        5,500
	Incremental depreciation		$       18,500	$     32,900	$      17,540	$        8,324	$        8,324
	Incremental NOI		$       11,500	$      -2,900	$      12,460	$     21,676	$      21,676
	Tax at 35%		$         4,025	$      -1,015	$         4,361	$        7,587	$        7,587
	Incremental NOPAT		$         7,475	$      -1,885	$         8,099	$     14,089	$      14,089
	Add: Incremental depreciation		$       18,500	$     32,900	$      17,540	$        8,324	$        8,324
	Incremental OCF		$       25,975	$     31,015	$      25,639	$     22,413	$      22,413
	Incremental salvage value:
	After tax salvage value of new machine = 10000-(10000-6912)*35% =						$        8,919
	After tax salvage value of old machine = 20000*(1-35%) =						$      13,000
	Incremental after tax salvage value = 8919-13000 =						$      -4,081
	Incremental project cash flows		$       25,975	$     31,015	$      25,639	$     22,413	$      18,333
d)	PVIF at 16% {PVIF = 1/1.16^t]		0.86207	0.74316	0.64066	0.55229	0.47611
	PV at 16%		$       22,392	$     23,049	$      16,426	$     12,379	$        8,728
	Total PV of CFS t1 to t5	$      82,974
	Less: Initial investment	$      87,625
	NPV	$       -4,651
e)	As the NPV is negative, the replacement should not be done.