Although the Chen Company's milling machine is old, it is still in relatively good working order and would last for another 10 years. It is inefficient compared to modern standards, though, and so the company is considering replacing it. The new milling machine, at a cost of $40,000 delivered and installed, would also last for 10 years and would produce after-tax cash flows (labor savings and depreciation tax savings) of $8,000 per year. It would have zero salvage value at the end of its life. The Project cost of capital is 9%, and its marginal tax rate is 35%. Should Chen buy the new machine?

Question

Jimena Mckenzie

Business

24 January, 20:34

Although the Chen Company's milling machine is old, it is still in relatively good working order and would last for another 10 years. It is inefficient compared to modern standards, though, and so the company is considering replacing it. The new milling machine, at a cost of $40,000 delivered and installed, would also last for 10 years and would produce after-tax cash flows (labor savings and depreciation tax savings) of $8,000 per year. It would have zero salvage value at the end of its life. The Project cost of capital is 9%, and its marginal tax rate is 35%. Should Chen buy the new machine?

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Answers (1)

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Kade Chaney · Answer 1

Chen should buy the machine

Explanation:

Buying of the new milling machine would make a business sense if the net present value of the new machine is positive.

By net present value I mean if the today's worth of the asset considering its initial cash outflow and subsequent cash inflows bring about a positive worth today.

Net present value=initial cost-cash inflows (discounted to today's terms)

Net present value=-$40,000 + ($8000*6.4177)

=-$40,000+51341.6

=$11,341.60

The 6.4177 is the annuity factor for 9% cost of capital for 10 years.

Since the project has a positive net present value, Chen should buy the machine