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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 equipment Category: Business and Money > Finance Asked by: dj555-ga List Price: \$20.00 Posted: 19 Aug 2006 10:04 PDT Expires: 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.```
 ```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 be paid today for the replacement, and a net \$816,000 will be "received" each year for the next 5 years. Therefore, at a 12% required rate of return, the present value of the replacement is: NPV = -3,324,000 + 816,000/1.12 + 816,000/1.12^2 + ... + 816,000/1.12^5 NPV = -382,503 Since the NPV is negative, the machine should not be replaced. I've also written this analysis in an Excel file. You can download it from http://www.filefactory.com/file/bfe534/ For another "Replacement Problem" example, look at this pdf document: http://www.utdallas.edu/~rabih/docs/oh_ch10.pdf#search=%22%22after%20tax%20salvage%20value%22%22 I hope this helps! If you have any doubt regarding my answer, please don't hesitate to request clarification before rating it. Otherwise, I await your rating and final comments. Best wishes! elmarto```
 dj555-ga rated this answer: and gave an additional tip of: \$10.00 ```Thank you! Fully answered, with a clear explanation for each step. Your inclusion of the Excel file was above and beyond. Thank you for a job well done.```
 ```Actually, there is not enough information to answer the question. 1. One must know the life of the old and new machine. I know it will fully depreciate in 5 years. That is merely an accounting (tax) schedule. the machines may survive and be productive well beyond the five year. So, unless you are assuming that the machines life matches the depreciation schedule, you do not have sufficient information to answer the question.```