Example of Replacement of Assets
Estate Developers purchased a machine five years ago on a cost of £7,500. The machine had a probable economic life of 15 years at the moment of purchase and a zero estimated salvage value at the ending of 15 years. It is being depreciated on a straight line origin and presently has a book value of £5,000. The Financial Manager has conducted a feasibility study aimed at acquiring a new machine for £12,000 and is depreciated over its 10 years useful life. The new machine will expand sales from of £10,000 to of £11,000 per annum and will decrease labor and materials usage enough to cut operating cost from £7,000 to £5,000. The salvage value of the new machine is £2,000 at the ending of useful life. The modern market value of the old machine is of £1,000 and tax is 40 percent. The firms cost of capital is 10 percent. The financial manager wishes to create a decision on whether to replace the old machine along with a new one and he seek your held.
N.B.The decision to replace takes into account as given:
a) Add up the present value of the expected salvage value to the P.V. of the incremental cash flow.
b) Verify the incremental cash flows.
c) Approximation the actual cash outlay attributable to the new machine
d) Calculate the NPV of incremental cash flows.
e) Ascertain whether the NPV or total present value is positive or whether the IRR or internal rate of return exceeds the cost whether in case invest if it's positive.
Solution
a) Initial capital for new machines £
Cash price of new machine 12,000
Less market value of old machine (1,000)
Less tax shield on sale of old machine:
Market value 1,000
Less total book value 5,000
Loss on disposal 4,000
Tax shield = 40% x 4,000 (6,000)
Incremental initial capital 9,400
b) Depreciation of new machine = 12,000 - 2.000 /10 years 1,000
Depreciation of old machine = 5,000 - 0 / 10 yrs 500
Incremental depreciation 500
NB: The NBV of old machine after 5 years is of £5,000. This NBV will be depreciated over the maintaining 10 years.
Determine operating cash flows:
Incremental sales = 11,000 - 10,000 1,000
Savings in labor costs = 5,000 - 7,000 2,000
Incremental EBDT 3,000
Less incremental depreciation OR non-cash item (500)
Incremental EBT 2,500
Less tax @ 40% 1,000
Incremental EAT 1,500
Add back incremental depreciation 500
Annual cash flow 2,000
Terminal cash flows at end of year 10 are equal to incremental salvage value.
New machine salvage value 2,000
Less old machine salvage value 0
2,000
Compute the NPV @10 percent cost of capital:
P.V of cash flows = 2000 * 1-(1.1)^{-10} / 0.10 = 2,000*PVAF_{10%} , 10 = 2,000 * 6.145
12,290
P.V of salvage value =2000 * 1 / (1.1)^{10} = 2,000*PVIF_{10%}, 10 = 2,000 * 0.386
772
13,062
Less incremental initial capital (9,400)
Incremental N.P.V 3,662
Swap the old machine