Machine Replacement with Tax Considerations A computer chip manufacturer spent $2,500,000 to develop a special-purpose molding machine. The machine has been used for one year, and will be obsolete after an additional three years. The company uses straight-line (SL) depreciation for this machine.
At the beginning of the second year, a machine salesperson offers a new, vastly more efficient machine. It will cost $2,000,000, will reduce annual cash manufacturing costs from $1,800,000 to $1,000,000, and will have zero disposal value at the end of three years. Management has decided to use the double-declining-balance depreciation method for tax purposes for this machine if purchased. (Note: make sure to switch to SL depreciation in year 3 to ensure that the entire cost is written off. You may find it useful to use the VDB function in Excel to calculate depreciation charges.)
The old machine’s salvage value is $300,000 now, and will be $50,000 three years from now; however, no salvage value is provided in calculating straight-line depreciation for tax purposes. The firm’s income tax rate is 45 percent. The firm desires to earn a minimum after-tax rate of return of 8 percent.
Required Using the net present value (NPV) technique, show whether the firm should purchase the new machine.
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