Three years ago, Dynamic Mechanics purchased a desktop testing machine for $7000

Question

Three years ago, Dynamic Mechanics purchased a desktop testing machine for $7000, and since that time, the resale or salvage value has been decreasing at a linear rate of $1000 per year. Maintenance and operating costs were $1600 the first year and have been increasing at a rate of $500 per year for each additional year of service. No exact projections are available, but it appears that both trends should continue for at least the next 3 years. At the end of that time, the equipment could be replaced by another unit with similar cost patterns. However, a new machine with a service life of 10 years is now available for a purchase price of $12,000 and no salvage value. A factory maintenance plan is also available at a fixed cost of $1500 per year on a contract basis.
Using a before-tax MARR of 25 percent, determine what replacement policy Dynamic Mechanics should follow with regard to this equipment. Assume that a need for this type of machine will exist for at least 10 years more

Explanation / Answer

Option 1 :- Using Existing Machine Year 1* Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Cash Outflow for :- Annual maintenance Cost          3,100          3,600          4,100          4,600 New Machinery Required          7,000 Maint. Cost on New Machinery          1,600          2,100          2,600          3,100          3,600           4,100 Resale Value of New Machine         (1,000) Total          3,100          3,600          4,100          4,600          8,600          2,100          2,600          3,100          3,600           3,100 PVF @ 25%          0.800          0.640          0.512          0.410          0.328          0.262          0.210          0.168          0.134           0.107 Present Value          2,480          2,304          2,099          1,884          2,818             551             545             520             483               333 Net Present Value of Outflow       14,017 * Year 1 is the the forth year for existing machine as it is purchased three years ago. Maint Cost for Year 1* = 1600+500+500+500 = $ 3100 Assume New Machine of Similar type cost = $ 7000 Resale Value of new Machine= $ 7000-6X1000 = $ 1000 as assume this type of machine not required after this. Option 2 :- Using New Machine Year 1* Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Cash Outflow for :- Annual maintenance Cost          1,500          1,500          1,500          1,500          1,500          1,500          1,500          1,500          1,500           1,500 New Machinery Required       12,000 Total       13,500          1,500          1,500          1,500          1,500          1,500          1,500          1,500          1,500           1,500 PVF @ 25%          0.800          0.640          0.512          0.410          0.328          0.262          0.210          0.168          0.134           0.107 Present Value       10,800             960             768             614             492             393             315             252             201               161 Net Present Value of Outflow       14,956 Net Present Value of Cash outflow of New machinery is Higher than the existing Machine. It is better to continue with the existing Machine subject to check the price of replacement of machinery after 4 years of exising machine. As in our assumption, we consider the same price as the last purchase on the history basis. For the purpose of Replacement Policy creation, Its better for Dynamics to analyse of NPV of Cash outflow and calculate the incremental impact.

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