A manager has to decide to sell an old machine or keep it with a major overhaul.

Question

A manager has to decide to sell an old machine or keep it with a major overhaul.

To sell: The machine can be sold at time zero for X dollars with zero book value. The selling value is taxable at the rate of 35%.

To keep: Keeping the machine requires a major overhaul cost of $400,000 at time zero. The overhaul cost is depreciable from time 0 to year 5 (over six years) based on MACRS 5-year life depreciation with the half year convention (table A-1 at IRS). In this case machine can produce and generate equal annual revenue of 300,000 dollars for five years (year 1 to 5) and salvage value of the machine will be $200,000 with zero book value at the end of year 5. The operating cost of the machine will be $120,000 per year from year 1 to year 5.

Calculate the sale value, X, that can break-even the NPV of keeping the machine. Consider 35% income tax rate and after-tax minimum ROR of 12%.

Explanation / Answer

Overhaul Cost 400000 Depreciation 5 years MACRS year 1 2 3 4 5 Depreciation rate 20% 32% 19.20% 11.52% 11.52% Annual revenue 300000 Annual Operating Cost 120000 Salvage Value 200000 Income Tax rate 35% ROR 12% Calculation of annual operating cash flows year 1 2 3 4 5 Annual Revenue 300000 300000 300000 300000 300000 Annual operating cost 120000 120000 120000 120000 120000 Depreciation 80000 128000 76800 46080 46080 EBIT 100000 52000 103200 133920 133920 Tax at 35% 35000 18200 36120 46872 46872 Net Income 65000 33800 67080 87048 87048 Operating cash flow 145000 161800 143880 133128 133128 Cash flows associated with the project year 0 1 2 3 4 5 Overhaul cost -400000 Operating cash flows 145000 161800 143880 133128 133128 Salvage value 200000 Total Cash flows -400000 145000 161800 143880 133128 333128 Discount factor at 12% 1 0.892857 0.797194 0.71178 0.635518 0.567427 (=1/(1+0.12)^n) Discounted flows -400000 129464.3 128986 102410.9 84605.25 189025.8 Net Present Value 234492.2 Let X be the value of the machine to be sold required to make the NPV of the keeping and operating the machine break-even That is X - NPV is machine kept = 0 X - 234492.20 =0 X = 234492.20

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