Suppose you need to decide whether to keep an old machine or replace it with a n

Question

Suppose you need to decide whether to keep an old machine or replace it with a new one:

New machine: If you decide to replace the old machine with a new one, it requires capital cost of $1,000,000 in year zero (and zero salvage value for the old machine). Capital cost is depreciable from year 1 to year 8 (over eight years) based on MACRS 7-year life depreciation with the half year convention (table A-1 at IRS). The new machine can produce income of $450,000 and operating cost of $150,000 per year for 8 years (from year 1 to year 8) and it will have salvage value of 200,000 at the end (with zero book value).

Old machine: Old machine can operate only until year 5 with the revenue and operating cost of $350,000 and $200,000 per year (from year 0 to year 5). Old machine will have zero salvage value.

Note that the old machine is already in place and operating. However, installing the new machine takes one year and revenue starts from year 1.

Consider income tax of 40% and minimum rate of return 10%. Construct incremental analysis and conclude which alternative is more economically satisfactory? Please show your work.

Explanation / Answer

1) Statement showing incremental initial investment

Statement showing depriciation

Statement showing NPV

Thus purchasing new machine is economical

Particulars Amount Amount Purchase price of new machine 1000000 Less: cash flow of old machine at year o Sales 350000 Operating cost 200000 Profit 150000 Tax @40% 60000 PAT/Cash flow 90000 Incremental cash out flow 910000

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