Suppose we are thinking about replacing an old computer with a new one. The old

Question

1. Suppose we are thinking about replacing an old computer with a new one. The old one cost us $360,000; the new one will cost $730,000. The new machine will be depreciated straight-line to zero over its five-year life. It will probably be worth about $135,000 after five years. The old computer was purchased 3 years ago and is being depreciated at a rate of $72,000 per year. It is expected to last five years from now and will be worth $50,000. We can sell it for $190,000. The new machine will save us $130,000 per year in operating costs. The tax rate is 38% and the discount rate is 14%. Should we replace it?

Explanation / Answer

Please note: The amount $ 360,000 paid for the old computer is sunk cost and not useful now.

Here's the detailed comparison and present value of cash flow calculations

Rate of return r 14.00% 14.00% Formula Case -> Old machine continued New machine bought and used Cash flow PV of Cash flow Year Cash flow PV of cash flow Explanation Cash flow PV of cash flow Explanation A A/(1+r)^0 0 $            -   $                -   $(540,000.00) $ (540,000.00) Salesvalue of old machine - Purchase value of new machine = 190k-730k B B/(1+r)^1 1 $            -   $                -   $ 175,220.00 $   153,701.75 Operating costs saved + tax saved on depreciation value C C/(1+r)^2 2 $            -   $                -   $ 175,220.00 $   134,826.10 Operating costs saved + tax saved on depreciation value D D/(1+r)^3 3 $            -   $                -   $ 175,220.00 $   118,268.51 Operating costs saved + tax saved on depreciation value E E/(1+r)^4 4 $            -   $                -   $ 175,220.00 $   103,744.31 Operating costs saved + tax saved on depreciation value F F/(1+r)^5 5 $ 50,000.00 $     25,968.43 Salvage value after 5 yrs $ 310,220.00 $   161,118.55 Operating costs saved + tax saved on depreciation value + Saalvage value NPV (needs to be >=0 to be feasible Sum of above PVs of cash flow NPV(A) $ 25,968.4332 NPV(B) $131,659.2171 $ 25,968.4332 < $131,659.2171 Hence Choose to buy New machine is the decision (NPV comparison)

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