A pharmaceutical company has some existing semi-automated production equipment t
ID: 2804133 • Letter: A
Question
A pharmaceutical company has some existing semi-automated production equipment that they are considering replacing. This equipment has a present MV of $57,000 and a B of $30,000. It has five more years of straight-line depreciation available (if kept) of $6,000 per year, at which time its BV would be $0. The estimated MV of the equipment five years from now (in year-zero dollars) is $18,500. The MV rate of increase on this type of equipment has been averaging 3.2% per year. The total operating and maintenance and other related expenses are averaging $27,000 (A$) per year.
New automated replacement equipment would be leased. Estimated operating and maintenance and related company expenses for the new equipment are $12,200 per year. The annual leasing cost would be $24,300. The after-tax MARR (with an inflation component) is 9% per year (im); t = 40%; and the analysis period is five years. Based on an after-tax, A$ analysis, should the replacement be made? Base your answer on the actual IRR of the incremental cash flow.
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Explanation / Answer
Scenario - Leasing Equipment
Income from sale of current equipment = MV of equipment = 57000
Annual operating & maintenance cost = 12200
Annual leasing cost = 24300
Total annual cost = 12200+24300 = 36500
MARR = 9%
We will have to discount all the annual costs to get costs at year 0
Discounted cost of year 1 = 36500/(1+9%)^1 = 33486
Discounted cost of year 2 = 36500/(1+9%)^2 = 30721
Discounted cost of year 3 = 36500/(1+9%)^3 = 28185
Discounted cost of year 4 = 36500/(1+9%)^4 = 25858
Discounted cost of year 5 = 36500/(1+9%)^5 = 23722
Total discounted costs (at year 0) = 33486+30721+28185+25858+23722 = 141972
Net Cost = Total Discounted cost - Inital receipt from sale of equuipment = 141972-57000 = 84972
Scenario - Use the current equipment
Annual operating and maintenance cost = 27000
Annual depreciation = 6000
Tax rate = 40%
Tax savings due to depreciation = 6000*40% = 2400
Net annual cost = 27000 - 2400 = 24600
We will have to discount all the annual costs to get costs at year 0
Discounted cost of year 1 = 24600/(1+9%)^1 = 22569
Discounted cost of year 2 = 24600/(1+9%)^2 = 20705
Discounted cost of year 3 = 24600/(1+9%)^3 = 18996
Discounted cost of year 4 = 24600/(1+9%)^4 = 17427
Discounted cost of year 5 = 24600/(1+9%)^5 = 15988
Total discounted costs (at year 0) = 22569+20705+18996+17427+15988 = 95685
MV of equipment 5 years from now (in year 0 dollars ) = 18500
Net Cost = Total discounted cost - MV of equipment (in year 0 dollar) = 95685 - 18500 = 77185
Since the net cost in the scenario of using the same equipment is less, the replacement should not be made
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