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 pre-tax or post-tax, we are going to assume the numbers are pre-tax.
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:
After-tax = Savings for one year x (1 – tax rate)
= $50,000 X (1 - .40)
Present-value = After-tax x (1 – 1/(required ROI)time)/required ROI
= $30,000 x (1 – 1/(1.105)) / 0.10
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?