Suppose you have to decide whether selling an old machine or keeping it with a m

Question

Suppose you have to decide whether selling an old machine or keeping it with a major overhaul:

A) Selling the machine at time zero for $750,000 with zero book value and paying the tax of 40%.

B) Keeping the machine, which requires a major overhaul cost of $1,000,000 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 for five years (year 1 to 5) and salvage value of the machine will be $250,000 with zero book value at the end of year 5. The operating cost of the machine will be $400,000 per year from year 1 to year 5.

Calculate the minimum annual revenue that machine has to generate to break-even the selling with NPV of keeping the machine. Consider 40% income tax rate and after-tax minimum ROR of 8%.

Explanation / Answer

The required NPV is as follows:

The annual revenue should be 755,000

As per the figures given; the NPV is -1204233 Particulars Year Cash flow discount rate Discounted cash flows Overhaul cost 0 -1000000 1 -1000000 Cash flows 1 -50000 0.925 -46250 2 -26000 0.857 -22282 3 -51600 0.793 -40918.8 4 -66960 0.735 -49215.6 5 -66960 0.6805 -45566.3 Net present value -1204233 Workings: Computation of cash flows Year 1 Year 2 Year 3 Year 4 Year 5 Annual revenue 250000 250000 250000 250000 250000 Less: Operating cost 400000 400000 400000 400000 400000 Depreciation 100000 160000 96000 57600 57600 Income -250000 -310000 -246000 -207600 -207600 Less: Tax save on loss @40% 100000 124000 98400 83040 83040 Net income -150000 -186000 -147600 -124560 -124560 Add: Depreciation 100000 160000 96000 57600 57600 Cash flows -50000 -26000 -51600 -66960 -66960 Computation of depreciation Year 1 Year 2 Year 3 Year 4 Year 5 Depreciable value 1000000 1000000 1000000 1000000 1000000 Rate of depreciation @ half year convention 10% 16% 9.60% 5.76% 5.76% 100000 160000 96000 57600 57600 Total 471200

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