Suppose you have to decide whether sell an old machine or ke

Suppose you have to decide whether sell an old machine or keep it with a major overhaul. You can:

A) Sell the machine at time zero for X dollars with zero book value and paying the tax of 40%.

B) Keep the machine, which requires a major overhaul cost of $1,000,000 at time zero. The overhaul cost is depreciable from time 0 to year 5 (over six years) based on MACRS 5-year life depreciation with the half year convention (table A-1 at IRS (https://www.irs.gov/publications/p946)). In this case machine can produce and generate equal annual revenue of 900,000 dollars for five years (year 1 to 5) and salvage value of the machine will be $250,000 with zero book value at the end of year 5. The operating cost of the machine will be $400,000 per year from year 1 to year 5.

Calculate the sale value, X, that can break-even the NPV of keeping the machine. Consider 40% income tax rate and after-tax minimum ROR of 12%.

Solution

0 1 2 3 4 5 Annual revenue 0 900000 900000 900000 900000 900000 Operating costs 0 400000 400000 400000 400000 400000 Depreciation 200000 320000 192000 115200 115200 Incremental NOI 300000 180000 308000 384800 384800 Tax at 40% 120000 72000 123200 153920 153920 Incremental NOPAT 180000 108000 184800 230880 230880 Add: Depreciation 200000 320000 192000 115200 115200 Incremental OCF 380000 428000 376800 346080 346080 Capital expenditure 1000000 -173040 Annual project cash flows -1000000 380000 428000 376800 346080 519120 PVIF at 12% 1 0.89286 0.79719 0.71178 0.63552 0.56743 PV at 12% -1000000 339286 341199 268199 219940 294563 NPV 463186 After tax salvage value of the machine: Salvage value 250000 Book value 57600 Gain 192400 Tax on gain at 40% 76960 After tax salvage value of the machine: 173040 Sale value X that can break even X: = 173040/0.60 = $     2,88,400 (Answer)