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. 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 38% and minimum rate of return 10%. Construct incremental analysis and conclude which alternative is more economically satisfactory? Please show your work.

Explanation / Answer

Statement of cash flows on incremental basis:

NPV = $7026

Since the NPV is positive hence, we conclude that replacing old machine with new machine is more economically satisfactory.

Year 0 1 2 3 4 5 Investment -250000 Savings in Operating cost net of tax 46500 46500 46500 46500 46500 Tax savings in depreciation 19000 30400 18240 10944 10944 5472 Cash flows per year -231000 76900 64740 57444 57444 51972 PVF@10% 1 0.909 0.826 0.751 0.683 0.621 Present value -231000 69902 53475 43140 39234 32275

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