Suppose you need to decide whether to keep a machine or replace it with a new on

Question

Suppose you need to decide whether to keep a machine or replace it with a new one: Old machine: Old machine can operate for 5 years with operating cost of $120,000 per year. New machine: Replacing old machine with new one requires capital cost of $250,000 in year zero (zero salvage value for old machine). Capital cost is depreciable from year 0 to year 5 (over six years) based on MACRS 5-year life depreciation with the half year convention (table A-1 at IRS). New machine can produce with lower operating cost of $45,000 per year for 5 years (from year 1 to year 5). Assume both machines produce similar good with similar value that yields similar revenue. Consider income tax of 40% and minimum rate of return 10%. Construct incremental analysis and conclude which alternative is more economically satisfactory? Please show your work.

Explanation / Answer

Ans

Workings

Initial Capital Cost -2,50,000.000 Incremental Savings in reduced cost( 120000-45000)        75,000.000 less Tax on Above 40%        30,000.000 Incremental Savings in reduced cost net of tax        45,000.000 PFAF                   3.791 Present value of reduction in cost    1,70,585.405 Present value of depreciation tax shield        74,074.672 Present Value    2,44,660.077 NPV           -5,339.92

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