Nuclear safety devices installed several years ago have been depreciated from a first cost of $200,000 to zero using MACRS. The devices can be sold on the used equipment market for an estimated $15,000, or they can be retained in service for 5 more years with a $9000 upgrade now and an OE of $6000 per year. The upgrade investment will be depreciated over 3 years with no salvage value. The challenger is a replacement with newer technology at a first cost of $40,000, n = 5 years, and S = 0. The new units will have operating expenses of $7000 per year.

Question

(a) Use a 5-year study period, an effective tax rate of 40%, an after-tax MARR of 12% per year, and an assumption of classical straight line depreciation (no half-year convention) to perform an after-tax AW-based replacement study.
(b) If the challenger is known to be salable after 5 years for an amount between $2000 and $4000, will the challenger AW value become more or less costly? Why?

Answer 1

(a) Study period is set at 5 years. The only option is the defender for 5 years and the challenger for 5 years.
Defender

First cost = Sale + Upgrade = 15,000 + 9000 = $24,000

Upgrade SL depreciation = $3000 year (years 1-3 only)
OE, years 1-5: = $6000
Tax saving, years 1-3: = (6000 + 3000)(0.4) = $3600
Tax savings, year 4-5: = 6000(0.4) = $2,400
Actual cost, years 1-3: = 6000 – 3600 = $2400
Actual cost, years 4-5: = 6000 – 2400 = $3600
AWD = -24,000(A/P,12%,5) - 2400 - 1200(F/A,12%,2)(A/F,12%,5)
= -24,000(0.27741) - 2400 - 1200(2.12)(0.15741)
= $-9458

Challenger

DR on defender = $15,000
DR tax = $6000
First cost + DR tax = $46,000
Depreciation = 40,000/5 = $8,000
Expenses = $7,000 (years 1-5)
Tax savings = (8000 + 7000)(0.4) = $6,000
Actual OE = 7000 – 6000 = $1000 (years 1-5)

AWC = –46,000(A/P,12%,5) – 1000
= –46,000(0.27741) – 1000
= $–13,761

Retain the defender since the AW of cost is smaller.

(b) AWC will become less costly, but the revenue from the challenger’s sale between
$2000 to $4000 will be reduced by the 40% tax on DR in year 5.