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Replacement of an asset

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Suppose we are thinking about replacing an old computer with a new one. The old one cost us \$576,000; the new one will cost \$1,168,000. The new machine will be depreciated straight-line to zero over its 5-year life. It will probably be worth about \$216,000 after five years.

The old computer is being depreciated at a rate of \$192,000 per year. It will be completely written off in three years. If we don't replace it now, we will have to replace it in two years. We can sell it now for \$304,000; in two years, it will probably be worth \$128,000. The new machine will save us \$208,000 per year in operating costs. The tax rate is 40 percent and the discount rate is 10 percent.
Required:

(a)
Suppose we recognize that if we don't replace the computer now, we will be replacing it in two years. Should we replace now or should we wait? Hint: What we effectively have here is a decision either to "invest" in the old computer (by not selling it) or to invest in the new one. Notice that the two investments have unequal lives. The EAC for investing in the new computer is \$_____, while the EAC for investing in the old computer is \$. Thus, we (should/should not) replace the old computer. (Do not include the dollar sign (\$)_____. Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16))

(b)
Suppose we consider only whether we should replace the old computer now without worrying about what's going to happen in two years. Should we replace it or not? Hint: Consider the net change in the firm's aftertax cash flows if we do the replacement. The NPV is \$_____ and thus we(should/should not) replace the old computer. (Do not include the dollar sign (\$). Negative amount should be indicated by a minus sign. Round your answer to 2 decimal places. (e.g., 32.16))

Solution Preview

New computer cash flows - \$1,168,000, annual depreciation 233,600; Salvage value 216,000; Savings from new machine \$208,000 per year; life 5 years
Operating Cash Flow = (\$208,000)(1 – .40) + (\$1,168,000 / 5)(.40) = \$218,240
Notice that the costs are positive, which represents a cash inflow. The costs are positive in this case
since the new computer will generate a cost savings. The only initial cash flow for the new computer
is cost of \$1,168,000. We next need to calculate the aftertax salvage value, which is:
Aftertax salvage value = \$216,000(1 – .4) = \$129,600
Now we can calculate the NPV of the new computer as:
NPV = –\$1,168,000 + \$218,214 (PVIFA10%,5) + \$129,600 / 1.105
NPV = I will allow you to work the NPV ...

Solution Summary

Suppose we are thinking about replacing an old computer with a new one. The old one cost us \$576,000; the new one will cost \$1,168,000. The new machine will be depreciated straight-line to zero over its 5-year life. It will probably be worth about \$216,000 after five years.

The old computer is being depreciated at a rate of \$192,000 per year. It will be completely written off in three years. If we don't replace it now, we will have to replace it in two years. We can sell it now for \$304,000; in two years, it will probably be worth \$128,000. The new machine will save us \$208,000 per year in operating costs. The tax rate is 40 percent and the discount rate is 10 percent.

\$2.19