Question

Hi, I need help with the below question:
X Corp. is considering the purchase of a new drill

press to replace the one currently being used.  The old press is expected to last another 5 years and have no salvage value. The old press has a current book value of $5,000  and can be sold today for $4,500.

The new drill press costs $17,000 and has an expected useful life of 5 years. Salvage value in year 5 is expected to be $2,000.  The new machine is expected to save the company $6,000 per year before taxes.

X Corp. uses straight-line depreciation and pay taxes at the rate of 40 percent.  The appropriate discount rate is 12 percent.  Assume that the sale price minus the book value of sold equipment is treated as a taxable gain (or loss, if negative).  Also, assume that the tax consequences of any sales are recognized at the time of the sale (i.e., year 0 in this case.)

a. If the old machine is replaced, what is the incremental effect on the firm’s after-tax cash flow in year 0?

b. What are the additional (years 1-5) incremental cash flow effects of the replacement?

c. What is the net present value of making the replacement?  Should the company replace the old press?

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