A special-purpose milling machine was purchased four years ago for $20,000. It was estimatedat that time that this machine would have a life of10 years, a salvage value of $1,000, and a cost ofremoval of $1,500. These estimates are still good.This machine has annual operating costs of $2,000,and its current book value is $13,000 (based on“alternative MACRS,” a straight-line depreciationwith a half-year convention with zero salvage value).If the machine is retained for its entire 10-year life,the remaining annual depreciation schedule would be$2,000 for years 5 through 10. A new machine that ismore efficient will reduce operating costs to $1,000,but it will require an investment of $12,000. The lifeof the new machine is estimated to be six years with asalvage value of $2,000. The new machine would fallinto the five-year MACRS property class. An offerof $6,000 for the old machine has been made, andthe purchaser would pay for removal of the machine.The firm’s marginal tax rate is 40%, and its requiredminimum rate of return is 10%.(a) What incremental cash flows will occur at theend of years 0 through 6 as a result of replacing the old machine? Should the old machine bereplaced now?(b) Suppose that the annual operating costs for theold milling machine would increase at an annualrate of 5% over the remaining service life of themachine. With this change in future operatingcosts for the old machine, would the answer inpart (a) change?(c) What is the minimum salvage value for the oldmachine at the year 0 so that both alternatives areeconomically equivalent?
A special-purpose milling machine was purchased four years ago for $20,000. It was estimated
at that time that this machine would have a life of
10 years, a salvage value of $1,000, and a cost of
removal of $1,500. These estimates are still good.
This machine has annual operating costs of $2,000,
and its current book value is $13,000 (based on
“alternative MACRS,” a straight-line
with a half-year convention with zero salvage value).
If the machine is retained for its entire 10-year life,
the remaining annual depreciation schedule would be
$2,000 for years 5 through 10. A new machine that is
more efficient will reduce operating costs to $1,000,
but it will require an investment of $12,000. The life
of the new machine is estimated to be six years with a
salvage value of $2,000. The new machine would fall
into the five-year MACRS property class. An offer
of $6,000 for the old machine has been made, and
the purchaser would pay for removal of the machine.
The firm’s marginal tax rate is 40%, and its required
minimum
(a) What incremental cash flows will occur at the
end of years 0 through 6 as a result of replacing the old machine? Should the old machine be
replaced now?
(b) Suppose that the annual operating costs for the
old milling machine would increase at an annual
rate of 5% over the remaining service life of the
machine. With this change in future operating
costs for the old machine, would the answer in
part (a) change?
(c) What is the minimum salvage value for the old
machine at the year 0 so that both alternatives are
economically equivalent?
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