Machine Replacement with Tax Considerations; Spreadsheet Application A computer

Question

Machine Replacement with Tax Considerations; Spreadsheet Application 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, reduce annual cash manufacturing costs from $1,800,000 to $1,000,000, and 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 on the old machine for tax purposes. The firm’s income tax rate is 45%. The firm desires to earn a minimum after-tax rate of return of 8%. Required: Using the net present value (NPV) technique, show whether the firm should purchase the new machine. (Note: Use the PV and NPV functions in Excel to calculate all present value amounts.)

Explanation / Answer

The question is to decide whether to replace the exisitng machine or not. In case the machine is to be replaced the incremental cash flows are as under: 1) Initial cash outflow: cost of the new machine 2000000 less salvage value of old machine -300000 Tax shield on loss on sale of old machine = (1875000-300000)*.045 -708750 net cash outflow at t=0 991250 2) annual operating cash flows (incremental) 1 2 3 annual savings in expenses 800000 800000 800000 less tax @ 45% -360000 -360000 -360000 post tax savings 440000 440000 440000 add: tax shield on incremental depreciation @ 45% 318780 -81260 -181270 net after tax yearly cash inflows 758780 358740 258730 PVIF @ 8% 0.9259 0.8573 0.7938 PV 702574 307562 205388 Total PV 1215524 3) Terminal cash flows salvage value-new machine 0 salvage value of old machine 50000 less: tax @ 45% 22500 net salvage value of old machine 27500 incremental net terminal cash flow = -27500 PV at 8% (27500*.7938) -21830 4) NPV of the replacement PV of annual incremental cash inflows 1215524 PV of incremental terminal cash flows -21830 Less: Initial investment -991250 NPV 202445 SINCE THE NPV OF THE INCREMENTAL CASH FLOWS IS POSITIVE, THE OLD MACHINE SHOULD BE REPLACED. Work sheet for depreciation: New Machine: depreciation rate - DDB % switching to 66.67% 66.67% 100% SL in the third year 2000000 666600 222178 beginning book balance of the machine 1333400 444422 222178 depreciation expense for the year Old machine: depreciation straight line basis 625000 625000 625000

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