Question

Capital Budgeting

Problem 1

Precision Instruments operates a machine that was purchased at a cost of $580,000 three years ago. Its current market value is $240,000 less than the original purchase price. An improved version of the equipment is now available for $600,000. The firm has spent $20,000 on a study examining the feasibility of replacing the old machine with the new and found that the new machine is capable of performing the same functions as the old one. Both machines belong to CCA class 10 (CCA rate = 30%) and have an expected remaining useful life of four years, but while the older machine will be worth only $60,000 by that time, the new machine can be sold for $250,000 in four years. Management believes that the company will have other class 10 assets in four years when the new equipment would be sold. The cost of operating the old machine is expected to be $100,000 next year (i.e. t = 1) with this cost increasing at 4% per year over the next three years. Management estimates that the cost of operating the new machine will be $50,000 in its first year of operation (i.e. t = 1) and will increase at the same rate as the old machine. In addition, the more efficient new machine will immediately reduce the amount of net working capital (NWC) required by $30,000. The firm’s marginal corporate tax rate is 35% and the required rate of return is 12%. Should the firm replace the machine?

Answer 1

As we are deciding that, should we replace this old machine with new one or not?

First case - To deciding this factor we are taking first case as we are keeping first old machine

3 years ago the machine cost were = $580,000

Current market value of the machine = $240,000

Operating cost for next year (remaining one year cost ) = $100,000

As we know that cost of operating to the machine is increasing by 4% rate ,in above case we have $100,000 expenses in fourth year ,so now we can determine the operating cost of first 3 years in a decreasing order –

Operating cost for third year = $100,000/ (100%+4%)

                                                 = $96153.85

Operating cost for second year in the same way would be =$ 89031.34

Operating cost for fourth year in the same way would be = $ 79492.27

CCA is 30%

So after 4 years reaming value of the old machine would be = $240,000 (current value )

After 4^th year exhausted the remaining value of the old machine = $60,000                                                                                                         

So if we calculate total expenses for the old machine during till date & next year as well, we get the total money expenses would be =

=Machine cost($580,000)+ operating cost for four years($100,000+$ 92455.62+$89031.34+$ 79492.27) - $60,000 ( if we sell machine in after completion of fourth year)

= $580,000+$348015.9 - $60,000

=$868015.9

This is the total expenses and we are in exhausted fourth year of old machine’s life)

Second Case

As we are deciding that, should we replace this old machine with new one or not?

Second case - To deciding this factor we are taking second case as we are replacing old machine to the new one

Current market value of the machine = $600,000

Expenses on study of feasibility of new machine = $20,000

Operating cost for first year = $50,000

Operating cost is increasing by 4% year by year

Operating cost for the second year = $50,000*1.04

                                                              = $ 52000

Operating cost for the second year= $50,000* 1.08

                                                               = $ 54000

Operating cost for the second year= $50,000* 1.12

                                                              = $56,000

CCA is 30%

So after 4 years reaming value of the new machine would be = $250,000 (current value )                                                                                                          

So if we calculate total expenses for the new machine till the end of the machine’s life (fouth year) if we replaced today    

=Machine cost($600,000)+ operating cost for four years($50,000+$ 52,000+$54,000+$ 56,000) - $250,000 ( if we sell machine in current year)

= &600,000+$$212,000 - $250,000

=$812,000 – $250,000 - $ 30,000 operating saving

=$532,000 (this is the total expenses and we have exhausted fourth year of new machine’s life)

So here we can see the cost to maintain first machine (old machine ) would be higher by replacing with the new machine ,the finally we are recommending to replace the old machine with the new one that wold be a good decision .