Carob Company was planning to replace the four hand-loaded machines with an automatic machine. To determine whether the new machine investment is worth making, we calculate the net present value (NPV) of the investment. If the NPV is positive, Carob should buy the new machine and sell the old machines, otherwise, it should maintain the status quo.
There are several assumptions made:
1. The income tax rate is 40%.
2. The company uses straight-line depreciation and assumes no terminal disposal value for the new machine.
3. The tax effects of cash inflows and outflows occur at the same time that the cash flows occur.
4. The company’s required rate of return is 20%.
5. The company will sell the four old machines upon the purchase of the new machine.
6. Each shift lasts for 8 hours.
We use differential approach for decision making. We compare (1) the after-tax cash outflows as a result of replacing the old machines with (2) the savings in the future after-tax cash outflows by using the new machine rather than the old machines.
There are three categories of cash flows in this case:
1. Net initial investment, which is the cost of the new machine minus the after-tax cash flow from current disposal of the old machines.
2. After-tax cash flow from operation, including the labour cost savings and tax gain from additional depreciation.
3. After-tax cash flow from terminal disposal of the old machines.
NPV calculations:
4 Old Machines New Machine
Age 3 0
Annual Output (units per machine) 15,000 60,000
Shifts per day 2 2
Days per week 5 5
Labour required 4 1
Total cost $ 295,000 $ 340,000
Useful life (years) 15 12
Terminal disposal price $ ...