An outmoded paper machine was purchased eight years ago. Its annual operating co

Question

An outmoded paper machine was purchased eight years ago. Its annual operating costs are $60,000. It has been fully depreciated. It is expected to last four more years and have a salvage value of $40,000. A newer model of the machine will cost $225,000, have a life of twelve years, and have a salvage value of $50,000. Its annual operating cost is $20,000. Show pretax cash flow diagrams for each option. Label as necessary. Choose an appropriate method of analysis and recommend whether to replace the machine. Use a MARR of 12% and pretax analysis.

Explanation / Answer

It is a replacement problem. Existing machine was purchased eight years back. Its total purchase value has already depreciated. Thus book value is nil. But it can provide four more years of service with annual operating cost of $60,000. After four years it will realize scrap value of $40,000.

If new machie is purchased, then it will cost $225,000. It will render 12 years service with annual maintenance cost of $20,000. Its salvage value is $50,000.

Cash flow diagram of two machines are shown below:

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In order to recoommend replacement of machine, calculate total present value of total machine. The divide it by number of years. If old machine has lowest cash outflow, then do not replace. Calculations are shown below:

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Result: Average annual cash outflow is less for new machine, therefore replacement is suggested.

Calculation of old machine Time Machie Operating Salvage Net cash Present Yearly cost cost value flow value of $ Present value 0 $0.00 $0.00 1 $0.00 1 -$60,000.00 -$60,000.00 0.89285714 -$53,571.43 2 -$60,000.00 -$60,000.00 0.79719388 -$47,831.63 3 -$60,000.00 -$60,000.00 0.71178025 -$42,706.81 4 -$60,000.00 $40,000.00 -$20,000.00 0.63551808 -$12,710.36 Total present value -$156,820.24 Average yearly present value -$39,205.06

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