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Calculating NPV and IRR for a Replacement

A firm is considering an investment in a new machine with a price of $2 million to replace its existing machine. The current machine has a book value of a $1 million and a market value of $9 million. The new machine is expected to have a four-year life, and the old machine has four years left in which it can be used. If the firm replaces the old machine with the new machine, it expects to save $8 million in operating costs each year over the next four years. Both machines will have no salvage value in four years. If the firm purchases the new machine, it will also need an investment of $500,000 in net working capital. The required return on the investment is 18 percent, and the tax rate is 39 percent.

a. What are the NPV and IRR of the decision to replace the old machine?

b. The new machine saves $32 million over the next four years and has a cost of $32 million. When you consider the time value of money, how is it possible that the NPV of the decision to replace the old machine has a positive NPV?

Solution Preview

Please see the Excel file for calculations.

a. What are the NPV and IRR of the decision to replace the old machine?

The NPV comes to -5,103,892 and the IRR is 7.87%

b. The new machine saves $32 million ...

Solution Summary

The solution explains how to evaluate a machine replacement decision using NPV and IRR. Calculations are formatted in the attached Excel file.

$2.19