Question

One year ago, your company purchased a machine used in manufacturing for $120,000. You have learned that a new machine is available that offers many advantages; you can purchase it for $200,000 today. It will be depreciated on a straight-line basis over 5 years, after which it has no salvage value. You expect that the new machine will produce EBITDA (earnings before interest, taxes, depreciation, and amortization) of $100,000 per year for the next 5 years. The current machine is expected to produce EBITDA of $45,000 per year. The current machine is being depreciated on a straight-line basis over a useful life of 6 years, after which it will have no salvage value, so depreciation expense for the current machine is $20,000 per year. All other expenses of the two machines are identical. The market value today of the current machine is $80,000. Your company's tax rate is 45%, and the opportunity cost of capital for this type of equipment is 12%. Is it profitable to replace the year- old machine?

Answer 1

Particulars	Amount (in $)
Incremental cashflow
Purchase of new machine	200000
Saleof old machine	-80000
Net initial outflow	120000
Incremental operating cash flow
EBIDTA of new machine	100000
EBITDA of old machine	-45000
Annual incremental profit	55000
Less- Tax @ 45%	-24750
Annual profit after tax	30250
Present value factor @ 12% of 5 years	3.605
Present value	109051.25
Tax benefit on depreciation
Depreciation on new machine	40000
Depreciation on old machine	20000
Incremental depreciation	20000
Tax benefit on depreciation @ 45 %	9000
Present value factor @ 12% of 5 years	3.605
Present value	32445
Terminal cashflow
sale of new machine	0
sale of old machine	0
total present value	0
NPV (inflow-outflow)	21496.25

NPV is positive hence machine can be replaced.