Case Scenario:
Schmidt A.G. is considering the replacement of three hand loaded block milling machines with an automatic milling machine. The three hand -loaded machine are only three years old and were purchased at a total cost of DM300,000. The useful life of the machines at the time of their purchase was estimated to be fifteen years. The salvage value at the end of the fifteen years was estimated to be zero.
Alternatively, Schmidt A.G. can replace the three hand-loaded machines with an automatic milling machine. The new machine would have the same capacity as the combined capacity of the three hand-loaded machines, would have a twelve year useful life, would be depreciated for tax purposes at a rate of DM 40,000 per year for twelve years, and would have zero salvage value. Cost of the automatic milling machine is DM 480,000. The automatic machine would result in pre-tax labor savings, including benefits, of DM 135,000 per year. Other out of pocket cash savings, were estimated at DM 25,000 per year, before taxes. Based on the charge made for each square meter of floor space, the machining department would save DM 3,000 in the annual charge for space. No alternative use of the space was anticipated.
If Schmidt acquires the automatic milling machine, it will sell the three hand-loaded machines immediately for a total price of DM 100,000. The loss of DM 140,000 (the book value of DM 240,000 at the end of the third year minus the sale price of DM 100,000) resulting from the sale will be a tax-deductible expense.
No inflation is anticipated. Schmidt A.G. uses a discount rate of 7% to evaluate cost reduction projects.
Is the investment in the automatic milling machine economically attractive?
1) What are the actual, after-tax cash flows for each of the two alternatives?
2) What is the net present value of the actual cash flows for each of the two alternatives?