A lathe for trimming molded plastics was purchased 10 years ago at a cost of $7,500.

The machine had an expected life of 15 years at the time it was purchased, and management
originally estimated, and still believes, that the salvage value will be zero at
the end of the 15-year life. The machine is being depreciated on a straight-line basis;
therefore, its annual depreciation charge is $500, and its present book value is $2,500.
The R&D manager reports that a new special-purpose machine can be purchased
for $12,000 (including freight and installation), and, over its five-year life, it will reduce
labor and raw materials usage sufficiently to cut annual operating costs from
$9,000 to $4,000. This reduction in costs will cause before-tax profits to rise by
$9,000  $4,000  $5,000 per year.
It is estimated that the new machine can be sold for $2,000 at the end of five years;
this is its estimated salvage value. The old machine’s actual current market value is
$1,000, which is below its $2,500 book value. If the new machine is acquired, the old
lathe will be sold to another company rather than exchanged for the new machine.
The company’s marginal federal-plus-state tax rate is 40 percent, and the replacement
project is of slightly below-average risk. Net operating working capital requirements
will also increase by $1,000 at the time of replacement. By an IRS ruling,
the new machine falls into the 3-year MACRS class, and, since the cash flows are relatively This Model is prepared by Rajib Dahal. If you need
certain, the project’s cost of capital is only 11.5 percent versus 12 percent for excelsheet calculation, please contact me at my email at
an average-risk project. Should the replacement be made? rajib.dahal@nu.edu.kz/rajib.dahal@gmail.com
Appendix 11B: Replacement Project Analysis
Assumptions
Present Book Value of Old Machine 2,500.00 Depreciation Schedule for three year property class (for tax purpose)
Cost of New Machine 12,000.00 0.33 0.44 0.15 0.07
Saving of Costs due to New Machine 5,000.00 Year 1 Year 2 Year 3 Year 4
Annual depreciation of old machine 500.00
Salvage Value of new machine 2,000.00
Current salvage value of old machine 1,000.00 Change in WC 1,000.00
Tax rate 0.40 Cost of Capital 0.12
Discounted Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
0 1 2 3 4 5
Cash savings from new machine 5,000 5,000 5,000 5,000 5,000
D&A(New Machine) 4,000 5,334 1,777 889 0
D&A(Old Machine) 500 500 500 500 500
Change in D&A 3,500 4,834 1,277 389 (500)
Salvage Value of Old Machine 1,000
Gain from Salvage Value of Old Machine (1,500)
Salvage Value of New Machine 2,000
Gain from Salvage Value of New Machine 2,000
Cashflow before taxation 1,500 166 3,723 4,611 7,500
Taxation (600) 600 66 1,489 1,844 3,000
Cash flows after taxation 900 100 2,234 2,766 4,500
Add: Change in D&A 3,500 4,834 1,277 389 (500)
Add: Capex (12,000)
Add: Change in WC (1,000) 1,000
Transaction Cashflow (11,400) 4,400 4,934 3,511 3,156 5,000
Discount Factor 1.000 0.897 0.804 0.721 0.647 0.580
DCF (11,400) 3,946 3,968 2,533 2,042 2,901
NPV 3,990