Question

Pilot plus Pens is deciding when to replace its old machine. The old machine’s current salvage value is $2 million. Its current book value is $1 million. If not sold, the old machine will require maintenance costs of $400,000 at the end of the year, for the next five years. Depreciation on the old machine is $200,000 per year. At the end of five years, the old machine will have salvage value of $200,000 and a book value of $0. A replacement machine costs $3 million now and requires maintenance costs of $500,000 at the end of each year during its economic life of five years. At the end of five years, the new machine will have a salvage value of $500,000. It will be fully depreciated by the straight-line method. In five years, a replacement machine will cost $3,500,000. Pilot will need to purchase this machine regardless of what the choice it makes today. The corporate tax rate is 34% and the appropriate discount rate is 12%. The company is assumed to earn sufficient revenues to generate tax shields from depreciation. Should Pilot Plus replace the old machine now or at the end of five years?

please give detail in hand, do not use excel

Answer 1

Old Machine
Current Book Value	1,000,000
Current Salvage Value	2,000,000
Maintenance Cost /Year	400,000
Depreciation/Year	200,000
Total Cost/Year	600,000
Tax Shield	204,000
600000*.34
Total Actual Cash Outflow/Year	196,000
400000-204000

New Machine
Cost of Purchase	3,000,000
Salvage Value	500,000
Current Salvage Value of Old Machine	2,000,000
Maintenance Cost /Year	500,000
Depreciation/Year	500,000
2500000/5
Total Cost/Year	1,000,000
Tax Shield	340,000
1000000*.34
Total Actual Cash Outflow/Year	160,000
500000-340000
Opportunity Interest Cost	120,000
(3000000-2000000)*.12

Thus if we do not consider Opportunity Interest Cost replacement with New Machine now is viable but if we consider Opportunity Interest Cost then we should not go for replacement.