Please show your work and write solutions in details, including formulas and how
ID: 2651409 • Letter: P
Question
Please show your work and write solutions in details, including formulas and how you plug numbers, given in each question, into these formulas. Please, write short VERBAL conclusion at the end of each problem summarizing your answer in words. Verbal answers are not substitute for the quantitative solution.
Question 6
One year ago your company purchased a machine for $110,000. You have learned that the new, much better machine is available for $150,000. In will be depreciated on a straight line basis and has no salvage value. You expect the machine to produce $60,000 per year in revenue and cost $20,000 per year to operate for the next ten years. The current machine is expected to produce $40,000 per year in revenue and also costs $20,000 per year to operate. The current machine’s depreciation expense is $10,000 per for the next 10 years, after which it will be discarded. It will have no salvage value. The market value of the current machine today is $50,000. Your company’s tax rate is 45% and the opportunity cost of capital is 10%. Should your company replace its year-old machine?
Explanation / Answer
If the one year old machine is continued From today till the 9th year (because the life of old machine is 10 and 1 year has elapsed) Revenue per year 40000 Less: Cost per year 20000 Income before tax 20000 Less: Tax @45% 9000 Net Income 11000 Depreciation per year 10000 Depreciation tax shield 10000*45% 4500 Cash Flows: Net Income+ Depreciation Tax shield 15500 Additional cash flow in the 9th year from now 0 (as the machine has no salvage value) Computation of NPV Year Cash Flows Present Value factor@10% Present Value 1 15500 0.91 14090.91 2 15500 0.83 12809.92 3 15500 0.75 11645.38 4 15500 0.68 10586.71 5 15500 0.62 9624.28 6 15500 0.56 8749.35 7 15500 0.51 7953.95 8 15500 0.47 7230.86 9 15500 0.42 6573.51 10 0 0.39 0.00 Net Present Value 89264.87 If new machine is purchased Cash flows Today: Cost of new machine 150000 Less: Market value of old machine 50000 Cash Outflow Today 100000 Cash inflow every year for 10 years Revenue per year 60000 Less: Cost per year 20000 Income before tax 40000 Less: Tax @45% 18000 Net Income 22000 Depreciation per year= 150000/10 15000 Depreciation tax shield 15000*45% 6750 Cash Flows: Net Income+ Depreciation Tax shield 28750 Additional cash flow in the 9th year from now 0 (as the machine has no salvage value) Computation of NPV Year Cash Flows Present Value factor@10% Present Value 0 -100000 1.00 -100000.00 1 28750 0.91 26136.36 2 28750 0.83 23760.33 3 28750 0.75 21600.30 4 28750 0.68 19636.64 5 28750 0.62 17851.49 6 28750 0.56 16228.63 7 28750 0.51 14753.30 8 28750 0.47 13412.09 9 28750 0.42 12192.81 10 28750 0.39 11084.37 Net Present Value 76656.30 As the NPV is higher if old machine is continued, the one year old machine should be used in the production and the new machine need not be purchased