Bob owns a mill and is thinking of replacing the old machine with a new machine.
ID: 2586981 • Letter: B
Question
Bob owns a mill and is thinking of replacing the old machine with a new machine. The old machine has a historical cost of $30,000 and accumulated depreciation of $27,000 and has a trade-in value of $4,200. It currently costs $600 per month in utilities and another $5,000 a year in maintenance to run the machine. Bob feels that the machine can be used for another 15 years, after which it would have no salvage value. The new machine would reduce the utility costs by 30% and cut the maintenance cost in half. The new machine costs $49,000, has a 15-year life, and an expected disposal value of $4,000 at the end of its useful life. Bob charges customers $5 per hour to use the fitness center. Replacing the machine will not affect the price of service or the number of customers he can serve.
Question:
Bob wants to evaluate the new machine using capital budgeting techniques but does not know how to begin. To help him, read through the problem and separate the cash flows into four groups: (1) net initial investment cash flows, (2) cash flow savings from operations, (3) cash flows from terminal disposal of the investment, and (4) cash flows not relevant to the capital budgeting problem.
Assuming a required rate of return of 7%, and straight-line depreciation over remaining useful life of machines should bob buy the new machine
Explanation / Answer
1. Net initial investment cash flows = Cost of new machine - Trade-in value of old machine
= 49,000 - 4,200 = $44,800
2. Cash flow savings from operations:
On utilities = 600 x 30% x 12 = $2,160 per year
On maintenance = 5000 x 1/2 = $2,500 per year
So, total cash flow savings from operations = 2160 + 2500 = $4,660 per year
3. Cash flows from terminal disposal of the investment = Expected disposal value of new machine
= $4,000
4. Cash flows not relevant to the capital budgeting problem: Revenue from customers as it will remain same under both the alternatives.
Decision of buying:
For this, we will calculate the Net Present value (NPV) if Bob buys the machine.
NPV = Present value of icremental cash flows - Net Initial investment cash flow
Incremental cash flow per year = $4,660
Bob will get this incremental cash flow of 4,660 per year for 15 years. So, Present value of incremental cash flow for 15 years = 4660 x Cumulative discounting factor for 15 years @ 7% = 4,660 x 9.1079 = $42,443.
So, NPV = 42,443 - 44,800 = $ (2,357)
Since NPV is negative, Bob should not buy the new machine.
(The decision might change if the tax rate would have been given)