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Q: calculate the NPV of replacing existing equipment(Answered , 1 Comment)

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Subject: calculate the NPV of replacing existing equipmentCategory: Business and Money > Finance

Asked by: dj555-ga List Price: $20.00

Posted: 19 Aug 2006 10:04 PDTExpires: 18 Sep 2006 10:04 PDT

Question ID: 757649

ABC industries is considering a new assembly line costing $6,000,000.

The assembly line will be fully depreciated by the simplified straight

line method over its 5 year depreciable life. Operating costs of the

new machine are expected to be 1,100,000 per year.

The existing assembly line has 5 years remaining before it will be

fully depreciated and has a net book value of $3,000,000. If sold

today the company would receive $2,400,000 for the existing machine.

Annual operating costs on the existing machine are $2,100,000 per

year. ABC is in the 46 percent marginal tax bracket and has a

required rate of return of 12 percent.

Calculate the net present value of replacing the existing machine.

Answer

Subject: Re: calculate the NPV of replacing existing equipmentAnswered By: elmarto-gaon 21 Aug 2006 08:58 PDT

Rated:

Hello!

In order to find the present value of replacing the machine, we must

calculate the incremental cash flows that result from doing it.

First of all, notice that the new machine will represent a $1,000,000

savings per year in operating costs. Given that the tax rate is 46%,

then,

After-tax Savings in operating costs = (1 - 0.46)*1000000 = $540,000

There will also be some savings due to the fact that the depreciation

tax shield will be greater for the new machine. The depreciation for

the new machine will be $1,200,000 per year for the next 5 years

(since its cost is $6,000,000 and it will be depreciated straight line

during its 5-year life). The depreciation for the old machine would be

$600,000 per year (its current book value is $3,000,000 and it will be

depreciated straight line for the next 5 years until full

depreciation). Clearly, thus,

Incremental Depreciation = 1200000 - 600000 = $600,000

The tax shield generated by this depreciation will be:

Tax Shield = 0.46 * 600000 = $276,000

Therefore, we find that:

Incremental Cash Flows = 540000 + 276000 = $816,000 per year, for 5 years.

Let's now find the initial capital outlay. We know that the old

machine is being sold $2,400,000, while its book value is $3,000,000.

Therefore, the after-tax salvage value is:

After-Tax Salvage Value = 2400000 - 0.46*(2400000 - 3000000) = $2,676,000

Now, since the new machine costs $6,000,000, we get that the initial

capital outlay is: 6000000 - 2676000 = $3,324,000.

So now we have all the incremental cash flows generated by the

replacement of the machine. We know that a net $3,324,000 will have to

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