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The Woodruff Corporation purchased a piece of equipment three years ago for $230,000. It has an...

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Finance

The Woodruff Corporation purchased a piece of equipment threeyears ago for $230,000. It has an asset depreciation range (ADR)midpoint of eight years. The old equipment can be sold for$90,000.

A new piece of equipment can be purchased for $320,000. It alsohas an ADR of eight years.

Ye

New Equipment

OldEquipment                   Year

1

$80,000

$25,000                                 1

2

76,000

16,000                                  2

3

70,000

9,000                                     3

4

60,000

8,000                                    4

5

50,000

6,000                                     5

6

45,000

(7,000)                                   6

Assume the old and new equipment would provide the followingoperating gains (or losses) over the next six years:

Question: The firm has a 25 percent tax rate and a 9 percentcost of capital. Should the new equipment be purchased to replacethe old equipment? Explain your answer.

Answer & Explanation Solved by verified expert
4.4 Ratings (640 Votes)

ADR % Old eqpt.
14.29 1.BV (230000*43.73%) 100579
24.49 2.Sale value 90000
17.49 56.27 3.Loss on sale(1-2) 10579
12.49 43.73 4. Tax c/f saved on loss (3*25%) 2645
8.93 5.After-Tax salvage (2+4) 92645
8.92
8.93
4.46
100
Table-1 Opg. Gains/(loss)
Year New Equipment Old Equipment                     After-tax gain=Diff*(1-25%) PV F at 9% PV at 9%
1 2 3 4=(2-3)*(1-25%) 5=1/1.09^Yr.n 6=4*5
1 80000 25000 41250 0.91743 37844
2 76,000 16000 45000 0.84168 37876
3 70,000 9000 45750 0.77218 35327
4 60,000 8000 39000 0.70843 27629
5 50,000 6000 33000 0.64993 21448
6 45,000 -7000 39000 0.59627 23254
183378
Table-2 Tax shield
Old m/c ADR%*230000*25% New m/c ADR%*320000*25% Diff. in T/Shield PV F at 9% PV at 9%
Year ADR % ADR % (5-3)
1 12.49 7182 14.29 11432 4250 0.91743 3899
2 8.93 5135 24.49 19592 14457 0.84168 12168
3 8.92 5129 17.49 13992 8863 0.77218 6844
4 8.93 5135 12.49 9992 4857 0.70843 3441
5 4.46 2565 8.93 7144 4580 0.64993 2976
6 8.92 7136 7136 0.59627 4255
33584
PV of after-tax salvage of Old equipment
92645*0.59627---------- (P/F,i=9%;n=6) 55241
Purchase cost of new m/c -320000
PV of differential after-tax gain 183378
(As per Table -1)
PV of diffl.depn. Tax shield
(As per Table -2) 33584
NPV of the decision -47797
As the NPV of the decision to buy new m/c is NEGATIVE, REPLACEMENT is NOT recommended.

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