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Cash Flows and Decision Making

A company has a metal bending machine and is considering a replacement for the machine. If repaired, the existing machine can be used for another 5 years. The existing machine will have no salvage value at the end of 5 years if kept for that period; however, the firm can sell the existing machine today to another firm for $4,500. If the existing machine is kept, it will require an immediate $1,000 overhaul to enable continued operation. (The overhaul will not extend the service life beyond 5 years or increase the value of the existing machine). Operating costs for the existing machine are estimated at $1,500 for the first year and will increase by $500 each year after the first.

A new model will cost $10,000 and will have operating costs of $1,500 for the first year. For each additional year (after the first year) the new machine is used, its operating costs will increase by $750 over the previous year's operating costs. The new machine's salvage value is $7,500 after one year and declines by 15% from the previous year's salvage value each year.

The firm's MARR is 10%. Should the existing metal bending machine be replaced now?

Solution Preview

Please refer attached file for better clarity of tables.

In attached file
In row no. 28, "Cost of old machine as on today" should be read as "Cost of new machine as on today"
In row no. 45, "Total present cost if old machine is used" should be read as "Total present cost if new machine is used"

Case 1
Continue to use existing bending machine

Cost of old machine as on today=$4,500
Overhaul costs= $1,000
Total value of machine if used =$5,500
Salvage=$0

Let us analyze cash flows

Year End Machine Value Operating cost Salvage Net cash flow PW of Cn
n MV OC S Cn=MV+OC+S Cn/(1+10%)^n
0 ...

Solution Summary

Solution describes the steps to decide if the old machine can be replaced with the new one. Calculations are provided in MS Excel format.

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