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Replacing Machines

One year ago, your company purchased a machine used in manufacturing for $110,000.
You have learned that a new machine is available that offers many advantages; you can
purchase it for $150,000 today. It will be depreciated on a straight-line basis over 10 years,
after which it has no salvage value. You expect that the new machine will produce EBITDA
(earning before interest, taxes, depreciation, and amortization) of $40,000 per year for the
next 10 years. The current machine is expected to produce EBITDA of $20,000 per year.
The current machine is being depreciated on a straight-line basis over a useful life of 11
years, after which it will have no salvage value, so depreciation expense for the current
machine is $10,000 per year. All other expenses of the two machines are identical. The market
value today of the current machine is $50,000. Your company's tax rate is 45%, and the
opportunity cost of capital for this type of equipment is 10%. Is it profitable to replace the
year-old machine?

Solution Preview

This question can be answered through a series of formulas/calculations.

40,000 - 20,000 = 20,000 increase in EBITDA. Depreciation change = 15,000 (150,000 / 10) - 10,000 (current) = 5,000.

= 20,000 x (1-0.45) + (0.45) (5,000) = 13,250
= EBITDA change x 1 - tax rate + ...

Solution Summary

This solution shows the necessary calculations, answers, and explanations to determine if it is profitable to replace the year-old machine.