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The Problem
Step 1: Computing the Incremental Cash Flows
Step 2: Computing the Initial Outlay
Step 3: Computing the NPV and IRR
The Problem
Old equipment: book value = $600,000 with a remaining life of 5 years
Expected salvage value in 5 years = 0
Market value today = $265,000
Straight-line depreciation
Other information: 40% marginal tax rate and a 12% hurdle rate
What can the old machine be sold for? Zero. So forget that, too. Usually you need to
include any proceeds from selling the old machine as a cash inflow. Since the old
machine is being depreciated using straight-line, it is being depreciated to its
predicted salvage value. Thus, for nearly all problems, when using straight-line the
machine's predicted market value and its book value will both equal the expected
salvage value and, hence, there won't be any tax effect. But in this problem, the
expected salvage value and the book value are both 0.
The new machine can be sold for $145,000 but its book value at the end of the 5th
year is 70,500. Whenever any machine is sold for a price other than its book
value, there is a tax effect that you must consider. This could pertain to the old
machine or the new machine. The net proceeds from the sale is always MV - t(MV -
BV). Be careful of the signs--but this always works. In this example, 145,000 - .
4*(145,000 - 70,500) = 115,200. In the fifth year, there is this cash inflow of 115,200
from selling the new machine. This will make the total cash flows in the firth year
115,200 (nonoperating) + 156,700 (operating) = 271,900. Now let's solve for the
initial outlay.
It's the same formula and it's applied for the exact same reason: you're selling a
machine at a market value different from its book value. You gotta pay additional
taxes if it's a gain and you get a tax refund if the sale is at a loss. There's another way
of looking at the tax effect on the proposed new machine. Let's pretend that the firm
buys the proposed new machine today and the forecasts all hold. 5 years from now
they are considering buying another proposed new machine and you need to consider
the initial outlay of that purchase. The "old" machine (the one you bought today) has
a book value of 70,500. It can be sold for 145,000. The net proceeds is equal to
145,000 - .4*(145,000 - 70,500) = 115,200. Exactly what you did in the cash flow
section above but then it was the "new" machine being sold 5 years from now. In this
section it has now become the "old" machine and it is being sold 5 years from today
because the firm is considering buying a third machine.
Now let's combine the answers from Steps 1 and 2 to see if the replacement is
worthwhile.
YEAR CF
0 -776,000
1 199,000
2 255,400
3 194,300
4 161,400
5 271,900
The formula for NPV is:
r = 12.02% acceptable
We knew it was going to be slightly larger than 12% because when we calculated the
NPV using 12%, it was a very small $436.77.
Verify the answer using either your calculator or click the above button.