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St. Johns River Shipyard's welding machine is 15 years old, fully depreciated, and has no salvage value. However, even though it is old, it is still functional as originally designed and can be used for quite a while longer. The new welder will cost $81,000 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 10%. Should the old welder be replaced by the new one? What is the NPV of the project?

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The NPV of the cash flow for the project needs to be compared to the cash outlay to get to the NPV of the project. The first step is to determine what the cash flow is. Depreciation is an operating expense but does not require an outlay of cash, therefore it is not considered a cash flow item. However, it needs to be calculated to understand the tax implications since taxes are an outlay of cash and therefore a negative cash flow item. Since the asset has a life of 8 years, the cash flows are calculated for 8 years. Once you have the cash flow calculated, you can utilize the NPV function/formula in excel to calculate the NPV of the cash flows and subtract the initial investment to get to the NPV of the investment.

See below the calculation of cash flows:

 

Description of Item Comments/Formula   Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Initial Investment   ($81,000)  
Change in Earnings before Depr     $28,000 $28,000 $28,000 $28,000 $28,000 $28,000 $28,000 $28,000
Depr. MACRS Rate*Investment   ($16,200) ($25,920) ($15,552) ($9,331) ($9,331) ($4,666) $0 $0
Taxes 40% * (Change in Earnings-Depr)   ($4,720) ($832) ($4,979) ($7,468) ($7,468) ($9,334) ($11,200) ($11,200)
Chg in Net Earnings after Tax Sum of Chg in Earnings, Depr, Taxes   $7,080 $1,248 $7,469 $11,201 $11,201 $14,001 $16,800 $16,800
Add Back Depreciation Add Back Non-Cash Flow Item   $16,200 $25,920 $15,552 $9,331 $9,331 $4,666 $0 $0
Cash Flow Impact Chg in Earnings After Tax + Depr   $23,280 $27,168 $23,021 $20,532 $20,532 $18,666 $16,800 $16,800

Now that you have the cash flow, you can enter the function/formula below in excel which is NPV(rate,cash flow values). The rate is the WACC )Weighted Average Cost of Capital which in this example is 10%.

=NPV(0.1,23280,27168,23021,20532,20532,18666,16800,16800)

Versus typing in all the cash flow numbers, you can also use the range of cells in excel that contain the cash flow numbers.

The NPV of the cash flows using this formula is $114,680. You then subtract the initial investment of $81,000 to get to a net NPV of $33,680. Since this is a positive NPV, the company should consider replacing the old welder with a new one.

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