Gillian is deciding whether to replace an old machine, and has assembled some information (refer to attachment File #1). She believes that the second-hand market value of either machine will decline over time in line with the depreciation schedule (eg. the old machine should sell for $3,000 today). If there are no taxes, and Gillian's required rate of return is 15% p.a.:
1) What is the optimal replacement cycle for the new machine?
2) Should the old machine be replaced now or next year?
1) Optimal Replacement Cycle
Step 1: Find the Net Present Value (NPV) of the new machine for each of the 3 years.
NPV(n) = Current value + Cash Flow(1) +
Cash Flow(2) + Cash Flow(3) + ... +
Cash Flow(n) + Salvage Value(n)
where: Cash Flow = Revenue - Expenses
Salvage value = Current value - Depreciation
NPV(y1) = -12,000 + ...
Gillian is deciding whether to replace an old machine. Using NPV analysis, the solution calculates the optimal replacement cycle and projects when the machine should be replaced.