Question

St. Johns River Shipyards's welding machine is 15 years old, fully depreciated, obsolete, and has no salvage value. However, even though it is obsolete, it is perfectly functional as originally designed and can be used for quite a while longer. The new welder will cost $80,500, and have an estimated life of 8 years with no salvage value. The new welder will be much more efficient, however, and this enhanced efficiency will increase earnings before depreciation from $28,000 to $56,000 per year. The new machine will be depreciated over its 5-year MACRS recovery period, so the applicable depreciation rates are 20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76%. The applicable corporate tax rate is 40%, and the firm's WACC is 14%. Should the old welder be replaced by the new one?

Old welder -Select-should or should not be replaced?
What is the NPV of the project? Round your answer to the nearest cent.

Answer 1

The decision to replace the old welder with the new one will be based on calculating the Net Present Value (NPV) of the increased cash flows, considering the depreciation advantages and the cost of the new welder. A positive NPV indicates that the old welder should be replaced.

Step-by-step explanation:

To determine whether the old welder should be replaced by the new one, we'll need to calculate the Net Present Value (NPV) of the replacement project. The NPV is the value of all future cash flows over the life of the project discounted back to present value using the company's Weighted Average Cost of Capital (WACC).

The cash flows from the new welder come from the increased earnings before depreciation and taxes, which is an increase from $28,000 to $56,000 per year. To find the after-tax increase in earnings, we reduce the increased earnings by the corporate tax rate of 40%. This gives us an after-tax benefit of ($56,000 - $28,000) * (1 - 0.40) = $16,800 per year.

Next, we must account for depreciation. Since the new machine will be depreciated using the MACRS method over 5 years, the depreciation expenses for the 8-year life of the project will be:

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• Year 1: $80,500 * 20.00% = $16,100
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• Year 2: $80,500 * 32.00% = $25,760
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• Year 3: $80,500 * 19.20% = $15,456
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• Year 4: $80,500 * 11.52% = $9,277.60
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• Year 5: $80,500 * 11.52% = $9,277.60
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• Year 6-8: No depreciation

The tax savings from these depreciations are the depreciation amount multiplied by the tax rate. Therefore, the NPV of the tax shield would need to be calculated for each year.

Once the tax savings from depreciation are calculated for each year, we need to subtract the initial cost of the welder, $80,500, and discount all the after-tax benefits and the tax shield from depreciation back to present value using the firm's WACC of 14%. If the NPV is positive, it means the new welder is a good investment, and the old welder should be replaced.