The alternative to investing in the new production line is to overhaul the exist

Question

The alternative to investing in the new production line is to overhaul the existing line, which currently has both a book value and a salvage value of $0. It would cost $ 230,000 to overhaul the existing line, but this expenditure would extend its useful life to five years. The line would have a $0 salvage value at the end of five years. The overhaul outlay would be capitalized and depreciated using MACRS over three years. The tax rate is 35 percent, the opportunity cost of capital is 14 percent. The NPV of the new production line is $ -215,000 . Should ACME replace or renovate the existing line? (Round your intermediate calculations and final answer to the nearest dollar, e.g. 5,275. Enter negative amounts using either a negative sign preceding the number e.g. -45 or parentheses e.g. (45).) NPV of renovating old line $ Entry field with incorrect answer now contains modified data ACME should Entry field with correct answer the existing line.

Explanation / Answer

Acme is faced with the following 2 alternatives -

1. Introduce new production line

2. Overhaul the existing line

NPV of alternative 1 is already given as $ -215,000

Calculation of NPV of alternative 2

Outflow in Year 0 (i.e.today) will be $ 230,000, but since it is a capital expenditure, the same will be capitalised in the books and depreciation will be claimed on the same. Tax-savings will entail from these depreciation claims made by the company which will increase its NPV.

The asset falls under 3 years MACRS category and hence would be depreciated in the following manner -

(1)

Depreciation Rate

(2)=(1)*230000 Depreciation

(3)=(2)*35%

Tax Savings @ 35%

(4)

PV Factor

(3)*(4)

Present Value(PV)

Total of last column, i.e. $ 59,865 is the PV of Cash Inflows (PVCI). The PV of Cash Outflows (PVCO) is $ 230,000 as discussed above. That means NPV is as follows-

NPV = PVCI - PVCO

= $59,865 - $230,000

= $ -170,135

Thus now we compare NPV of both the alternatives. Clearly NPV of 2nd alternative is higher so we go with that option.

Notes

1. Here it is more like net PVCO rather than NPV. This is because we are comparing outflows only and probable inflows are ignored (being same in both cases). Thus decision is purely based on what results in least outflow. Thus instead of saying NPV is higher in alternative 2, it could well be said that net outflow is lesser in alternative 2, hence the choice.

2. Since MACRS system of depreciation has to be followed for tax purposes,the depreciation wold be based on 3 years MACRS system and actual life (which is extended to 5 years) would be ignored.

3. 200% declining balance method (with half-year convention) has been used for depreciation of an asset class of 3 years ( as per IRS requirements).

Year

(1)

Depreciation Rate

(2)=(1)*230000 Depreciation

(3)=(2)*35%

Tax Savings @ 35%

(4)

PV Factor

(3)*(4)

Present Value(PV)

1 33.33% 76659 26831 .8772 23536 2 44.45% 102235 35782 .7695 27534 3 14.81% 34063 11922 .6750 8047 4 7.41% 17043 1263 .5921 748

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