One year ago your company purchased a machine for $110,000. You have learned tha

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

Incremental revenues: 0

               Incremental costs: -150,000

               Depreciation: $10,000 per year

               Capital Gain on Salvage: $50,000 - $0 = $50,000

               Cash Flow from Salvage Value: +50,000 - (50,000)(0.45) = 27,500

               Execute: Replacing the machine increases EBITDA by 40,000 - 20,000 = 20,000. Depreciation expenses rises by $15,000 - $10,000 = $5000. Therefore, FCF will increase by (20,000) ´
(1 - 0.45) + (0.45)(5000) = $13,250 in years 1 through 10.

                        In year 0, the initial cost of the machine is $150,000. Because the current machine has a book value of $110,000 - 10,000 (one year of depreciation) = $100,000, selling it for $50,000 generates a capital gain of 50,000 - 100,000 = -50,000. This loss produces tax savings of 0.45 ´ 50,000 = $22,500, so that the after-tax proceeds from the sales including this tax savings is $72,500. Thus, the FCF in year 0 from replacement is -150,000 + 72,500 = -$77,500.

               NPV of replacement = -77,500 + 13,250 ´ (1/0.10)(1 - 1/1.1010) = $3,916. There is a small profit from replacing the machine.

                Evaluate: Even though the decision has no impact on revenues, it still matters for cash flows because it reduces costs. Further, both selling the old machine and buying the new machine involve cash flows with tax implication.

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