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Capital Budgeting: The payback period, NPV and Profitability Index

A company is considering replacing a five-year old machine that originally cost $50,000, presently has a book value of $25,000 and could be sold for $60,000. This machine is currently being depreciated using the simplified straight line method down to a terminal value of zero over the next five years, generating depreciation of $5,000 per year. The replacement machine would cost $125,000, and have a five year expected life over which it would be depreciated down using the simplified straight line method and have no salvage value at the end of five years. The new machine would produce savings before depreciation and taxes of $45,000 per year. Assuming a 34 percent marginal tax rate and a required rate of return of 10 percent, calculate:

1. The payback period

2. NPV

3. Profitability Index

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Solution Preview

The calculations are in the attached file. The net cost of the new machine is the purchase price less the sale of old machine. The old machine is sold above the book value, we need to take the after tax income on sale. The net cost of the new machine ...

Solution Summary

The solution explains how to calculate the cash flows for a replacement project and calculate the payback period, NPV and profitability index.