
Keep or buy?
5. Newfound must also look at the possibility of replacing another one of its machines. The current machine also cost $100,000. It was purchased when the company started on the Colliers waterfront in November of 2002. Newfound has a buyer for this machine today at $65,000. If they keep it they’ll have to hold on to it for another five years at which time they’ll get $10,000 from a scrap dealer. The new machine would cost $150,000 and save $50,000 in variable costs, but in five years it will be a worthless piece of junk! What would you do?
(CCA rates, tax rates and required return are given in question 4, if you really need ‘em!).
CCA rate  20%
Tax Rate 40%
required return  10%
Here’s what I’ve done so far...
Current Machine Cost: $100,000
Bought: November 2002
Salvage Value Now: $65,000
New Machine Cost: $150,000
Variable Cost savings: $50,000
Salavage Value at the end: 0
Tax rate: 40%
CCA Rate: 20%
Required Return On Investment: 10%
We know no matter what we choose, the current machine cost is irrelevant to us in this decision. It is a sunk cost. Because there is no reference to the savings being pretax or posttax, we are going to assume the numbers are pretax.
So, we should find the present value of our increased operating income (aka variable cost savings), assuming we decide to go with the new machine:
Aftertax = Savings for one year x (1 – tax rate)
= $50,000 X (1  .40)
= $30,000
Presentvalue = Aftertax x (1 – 1/(required ROI)time)/required ROI
= $30,000 x (1 – 1/(1.105)) / 0.10
= $113,723,60
Ok. Here's my questions:
1) Do we really need the CCA rate, tax rate, and required ROI?
2) I know I have to go after the NPV of the salvage value of the new machine. Can it be a negative number or is it 0?
Thanks,
Ibrox