Piliot plus pens is deciding when to replace its old machine. The machine\'s cur
ID: 2640762 • Letter: P
Question
Piliot plus pens is deciding when to replace its old machine. The machine's current salvage value is $2.34 million. Its current book value is $1.43 million. If not sold, the old machine will require maintenance costs of $975,000 at the end of the year for the next five years. Depreciation on the machine is $286,000 per year. At the end of five years, it will have a salvage value of $227,500 and a book value of $0. A replacement machine costs $5.46 million now and requires maintenance costs of $344,000 at the end of each year during its economics life of five years. At the end of five years, the new machine will have a salvage value of $780,000. It will be fully depreciated by the straight-line method. Pilot will need to purchase this machine regardless of what choice it makes today. The corporate tax rate 34 percent and the appropriate discount rate is 12 percent. 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?
Explanation / Answer
Since it is mention that new machine has to be purchased regardless what decision we made today so it is immaterial to include it in the calculation.
IF THE OLD MACHINE SOLD TODAY
Cash Flow = (2.34 - 1.43) * (1-0.34) = $0.6 million
IF THE OLD MACHINE IS SOLD AFTER 5 YEARS
Annual Cash Flow = ( -975,000 + -286,000) * (1-0.34) + 286,000 = -$546,260 outflow
Present value of outflow = -546,260 * PVAF(12%, 5years) = -$1,969,145 or -$1.97 million
Salvage value = 227,500 * (1-0.34) = $150,150
Present value of salvage value = 150,150 * PVF(12%, 5years) = $85,199 or $0.85 million
Net Cash flow = -$1.97 million + $0.85 million = -$1.12 million
DECISION:
Since, there is loss in keeping the machine for 5 years, thus, old machine should be sold today.