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Replacement decision

A toy company currently uses an injection-moulding machine that was purchased two years ago. This machine is being depreciated on a straight-line basis toward a $500 salvage value, and it has 6 years of remaining life. Its current book value is $2,600 and it can be sold for $3,000 at this time.

The firm is offered a replacement machine that has a cost of $8,000, an estimated useful life of 6 years and an estimated salvage value of $800. The machine will be depreciated over six years on a straight-line basis to its residual value. The replacement machine would permit an output expansion,
so sales would rise by $1,000 per year.

Even so, the new machine's much greater efficiency would still cause operating expenses to decline by $1,500 per year. The new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $500. The firm's marginal tax rate is 40 percent and its cost of capital is 15 percent. Should it replace the old machine?

Solution Preview

Old machine depr = (2600 - 500)/5 = $420/yr
BV0 = $2,600 , MV0 = $3000
New machine depr = (8000 - 800)/6 = $1,200/yr
Sales + $1,000/yr ; BT Operating Exp - $1,500/yr
Inventories + $2,000 , A/P + $500, ...