Pilot Plus Pens is deciding when to replace its old machine. The machine\'s curr
ID: 2644252 • Letter: P
Question
Pilot Plus Pens is deciding when to replace its old machine. The machine's current salvage value is $2.2 million. Its current book value is $1.4 million. If not sold, the old machine will require maintenance costs of $845,000 at the end of the year for the next five years. Depreciation on the old machine is $280,000 per year. At the end of five years, it will have a salvage value of $120,000 and a book value of $0. A replacement machine costs $4.3 million now and requires maintenance costs of $330,000 at the end of each year during its economic life of five years. At the end of the five years, the new machine will have a salvage value of $800,000. It will be fully depreciated by the straight-line method. In five years a replacement machine will cost $3,200,000. Pilot will need to purchase this machine regardless of what choice it makes today. The corporate tax rate is 40 percent and the appropriate discount rate is 8 percent. The company is assumed to earn sufficient revenues to generate tax shields from depreciation.
Calculate the NPV for new and old machines. (Enter your answers in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
Should Pilot Plus Pens replace the old machine now or at the end of five years?
Pilot Plus Pens is deciding when to replace its old machine. The machine's current salvage value is $2.2 million. Its current book value is $1.4 million. If not sold, the old machine will require maintenance costs of $845,000 at the end of the year for the next five years. Depreciation on the old machine is $280,000 per year. At the end of five years, it will have a salvage value of $120,000 and a book value of $0. A replacement machine costs $4.3 million now and requires maintenance costs of $330,000 at the end of each year during its economic life of five years. At the end of the five years, the new machine will have a salvage value of $800,000. It will be fully depreciated by the straight-line method. In five years a replacement machine will cost $3,200,000. Pilot will need to purchase this machine regardless of what choice it makes today. The corporate tax rate is 40 percent and the appropriate discount rate is 8 percent. The company is assumed to earn sufficient revenues to generate tax shields from depreciation.
Explanation / Answer
Cash flow from depreciation is calculated as depreciation * tax rate
PV of cash flows = Cash flow/(1+i)^n where is 8%, n number of year
Intial investment outlay here in new machine is tricky, total salvage value of old machine is 2,200,000 and book value is 1,400,000. so there would be capital gain tax on the sale fo old machinery that will be (2,200,000 - 1,400,000) = 800,000, capital gain tax would be 40% of 800,000 = 320,000, actual cash inflow from sale of old machinery would be 1,880,000, the cost of new machinery is 4,300,000, effective invetment outlay would be 4,300,000 - 1,880,000 = 2,420,000.
b) the company should replace the machinery now as the npv of old machine is very leass as compared to new machine.
Old Machine Cash flow PV of cash flow 0 2,200,000 Depreciation 1 (845,000) 112,000 (733,000) (678,704) 2 (845,000) 112,000 (733,000) (628,429) 3 (845,000) 112,000 (733,000) (581,879) 4 (845,000) 112,000 (733,000) (538,777) 5 (845,000) 112,000 120000 (613,000) (417,197) Total (2,844,986) NPV (5,044,986)