Benson Enterprises is deciding when to replace its old machine. The machine’s cu
ID: 2775193 • Letter: B
Question
Benson Enterprises is deciding when to replace its old machine. The machine’s current salvage value is $1.2 million. Its current book value is $1 million. If not sold, the old machine will require maintenance costs of $420,000 at the end of the year for the next five years. Depreciation on the old machine is $200,000 per year. At the end of five years, it will have a salvage value of $220,000. A replacement machine costs $3.5 million now and requires maintenance costs of $160,000 at the end of each year during its economic life of five years. At the end of five years, the new machine will have a salvage value of $540,000. It will be fully depreciated using the three-year MACRS schedule. In five years a replacement machine will cost $4,000,000. Pilot will need to purchase this machine regardless of what choice it makes today. The corporate tax is 35 percent and the appropriate discount rate is 10 percent. The company is assumed to earn sufficient revenues to generate tax shields from depreciation. Should Benson Enterprises replace the old machine now or at the end of five years?
Explanation / Answer
Replacing today:
Particulars
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Total
Cost of new equipment
3500000
3500000
Maintenance costs
160000
160000
160000
160000
160000
800000
Tax saved on depreciation
408292.5
544512.5
181422.5
90772.5
1225000
Salvage value
540000
540000
3500000
568292.5
704512.5
341422.5
250772.5
-380000
4985000
Discount factor @10%
1
0.909
0.826
0.751
0.683
0.6209
4.7899
3500000
516577.9
581927.325
256408.2975
171277.6175
-235942
4790249
Net costs are $4,790,249.
Replacing after 5 years:
Year
Particulars
Cash flow
Discount factor@10%
Discounted flow
0
1
0
1-5
Maintenance costs
160000
3.7907
606,512
1-5
Tax saved on depreciation
70000
3.7907
265,349
5
Salvage value
-540000
0.620921
-335,298
536,563
Net costs are $536,563.
Hence, it is recommended to replace after 5 years since the cost is low.
Particulars
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Total
Cost of new equipment
3500000
3500000
Maintenance costs
160000
160000
160000
160000
160000
800000
Tax saved on depreciation
408292.5
544512.5
181422.5
90772.5
1225000
Salvage value
540000
540000
3500000
568292.5
704512.5
341422.5
250772.5
-380000
4985000
Discount factor @10%
1
0.909
0.826
0.751
0.683
0.6209
4.7899
3500000
516577.9
581927.325
256408.2975
171277.6175
-235942
4790249
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