One year ago, your company purchased a machine used in manufacturing for $115,00
ID: 2718899 • Letter: O
Question
One year ago, your company purchased a machine used in manufacturing for
$115,000. You have learned that a new machine is available that offers many
advantages; you can purchase it for $165,000 today. It will be depreciated on a
straight-line basis over ten years and has no salvage value. You expect that the new
machine will produce a gross margin (revenues minus operating expenses other
than depreciation) of $45,000 per year for the next ten years. The current machine
is expected to produce a gross margin of $21,000 per year. The current machine is
being depreciated on a straight-line basis over a useful life of 11 years, and has no
salvage value, so depreciation expense for the current machine is $10,455 per year.
The market value today of the current machine is $50,000. Your companys tax rate
is 38%, and the opportunity cost of capital for this type of equipment is 11%. Should
your company replace its year-old machine?
Explanation / Answer
Evaluation of Replacement Proposal:
Year
Cash Flows (CF)
PVF (11%)
PV = CF*PVF
Cost of New Machine
0
$ (165,000.00)
1.00000
$ (165,000.00)
Sale value of Old Machine
0
$ 50,000.00
1.00000
$ 50,000.00
Tax saving on loss on sale of old Machine
0
$ 20,727.10
1.00000
$ 20,727.10
= ((Cost - Accumulated Depreciation )- Sale Value )* Tax rate
= ((115000 - 10455 )- 50000 )* 38%
Incremental tax saving on depreciation =
1 to 10
$ 2,297.10
5.88923
$ 13,528.15
= (New Machine Dep- Old Machine Dep) * tax rate
= (165000/10 - 10455) * 38%
Incremental Gross Margin net of tax =
1 to 10
14880
5.88923
$ 87,631.77
= (45000-21000)* (1-38%)
Net Present Value (Sum of PVs)
$ 6,887.03
Net present value is positive , hence company should replace its year-old machine.
Evaluation of Replacement Proposal:
Year
Cash Flows (CF)
PVF (11%)
PV = CF*PVF
Cost of New Machine
0
$ (165,000.00)
1.00000
$ (165,000.00)
Sale value of Old Machine
0
$ 50,000.00
1.00000
$ 50,000.00
Tax saving on loss on sale of old Machine
0
$ 20,727.10
1.00000
$ 20,727.10
= ((Cost - Accumulated Depreciation )- Sale Value )* Tax rate
= ((115000 - 10455 )- 50000 )* 38%
Incremental tax saving on depreciation =
1 to 10
$ 2,297.10
5.88923
$ 13,528.15
= (New Machine Dep- Old Machine Dep) * tax rate
= (165000/10 - 10455) * 38%
Incremental Gross Margin net of tax =
1 to 10
14880
5.88923
$ 87,631.77
= (45000-21000)* (1-38%)
Net Present Value (Sum of PVs)
$ 6,887.03
Net present value is positive , hence company should replace its year-old machine.
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