Your firm is considering whether to replace an existing machine with a new one.

Question

Your firm is considering whether to replace an existing machine with a new one. The existing machine was purchased five years ago for $200,000 and has an economic life of ten years, that is, it will last for another five years. It will have no salvage value. The operating costs for this machine are $25,000 per year. This machine can be sold today for $80,000. The new replacement machine will do exactly the same job as the existing machine. This machine costs $140,000 and has an economic life of five years and no salvage value. The operating costs for this machine are $17,000 per year. Your firm

Explanation / Answer

We have no revenue in this problem so we simply put 0. Cost savings are 25,000 so we put it under operating expense as -25,000. Since operating expenses are already negative, the -25,000 becomes positive because two negatives are a positive. We must subtract depreciation which is 20,000 for the new machine and 5,000 for the old machine. 50,000 divided by 10 years = 5,000. We subtract the 5,000 from 20,000 and have 15,000 depreciation. So, 25,000 operating expense - 15,000 depreciation = 10,000. Minus 35% tax = 10,000x.35 = 3,500 which leaves us with 10,000 - 3,500 = 6,500. Now, we add back the depreciation of 15,000. So, 6,500 + 15,000 = 21,500 incremental cash flow for year 1. So Replacing the machine wud be a better option!

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