One year ago your company purchased a machine for $110,000. You have learned tha
ID: 2651424 • Letter: O
Question
One year ago your company purchased a machine for $110,000. You have learned that the new, much better machine is available for $150,000. In will be depreciated on a straight line basis and has no salvage value. You expect the machine to produce $60,000 per year in revenue and cost $20,000 per year to operate for the next ten years. The current machine is expected to produce $40,000 per year in revenue and also costs $20,000 per year to operate. The current machine’s depreciation expense is $10,000 per for the next 10 years, after which it will be discarded. It will have no salvage value. The market value of the current machine today is $50,000. Your company’s tax rate is 45% and the opportunity cost of capital is 10%. Should your company replace its year-old machine?
Explanation / Answer
PV of Cash Flow
New Machine = 28750 x PVIFA (10%, 10) = 28750 x 6.145 = $176669
Old Machine = 15500 x PVIFA (10%, 10) = 15500 x 6.145 = $95248
Cash outflow if the new machine is purchased:
NPV if the old machine is continued to be used by the ompany for the coming 10 years
= $95248 [As the old machine was purchased one year ago, hence there will be no outflow of cash if the old machine is continued.]
NPV if the new machine is purchased
= $176669 - 77500
= $ 99169
Since the NPV for the new machine is more than the old one,
the old machine should be replaced by the new one.
Per Year Cash Flow After Tax New Machine Old Machine Revenue 60000 40000 Less: Operating Cost 20000 20000 Depreciation (150000/10) 15000 10000 35000 30000 Opearting Profit 25000 10000 Less: Tax @ 45% 11250 4500 Profit after tax 13750 5500 Add: Depreciation 15000 10000 Cash Flow after tax 28750 15500Related Questions
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