Question

As a result of improvements in product engineering, United Automation is able to sell one of its two milling machines. Both machines perform the same function but differ in age. The newer machine could be sold today for $50,000. Its operating costs are $20,000 a year, but in 5 years the machine will require a $20,000 overhaul. Thereafter operating costs will be $30,000 until the machine is finally sold in year 10 for $5,000.

The older machine could be sold today for $25,000. If it is kept, it will need an immediate $20,000 overhaul. Thereafter operating costs will be $30,000 a year until the machine is finally sold in year 5 for $5,000.

Both machines have been fully depreciated for tax purposes before this replacement decision.

The company pays tax at 35 percent. Cash flows have been forecasted in real terms. The real cost of capital is 12 percent.

(Note: the overhaul cost is a capital expenditure and straight line depreciation to zero is used)

Analyse which machine United Automation should sell by answering the following.

(a) Compute the cash flows and NPV of the newer machine if it is kept, without considering the cash flows associated with the older machine.            

(b) Compute the cash flows and NPV of the older machine if it is kept, without considering the cash flows associated with the newer machine.            

(c) Discuss, using the results of parts (a) and (b), which machine should be sold.           

(d) Discuss why the payback period cannot be used for the decision regarding which machine to keep.           

Answer 1

c) The Net Present Value costs of the older machine is lower than the newer machine. But the difference is not much. The newer machine has a life of 10 years while the older machine only has a life of 5 years. So if you calculate the Equivalent Annual cost, newer machine would be the better choice as it has a higher life. So, Older machine should be sold.

d) Payback period does not consider the whole life, so it cannot be used