Bob owns a mill and is thinking of replacing the old machine with a new machine.
ID: 2797455 • 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 cashflows = Old car trade in value + new machine purchase
= 4200 + 49000
= 44800
2. Cash flow saving from operation -
Cost saving in utilities = 30% of old machine utility cost = 30% of 600 which will come = 180
and Cost saving in maintinance = 50% of old machine maintinance cost
= 50% of 5000
= 2500
Total cost flow saving from operation = 2500+180 = 2680
3. Cash flow from terminal disposal of the investment = salvage value of new machine which would be 4000
4. Cash flows not relevant to capital budgeting problem = old machine accumulated dep. 27000, old machine cost 30000.
calculation of decision making for purchasing new machine -
Conclusion - Bob would not buy the new machine as it has negative NPV.
Please comment in case of any clarification required or query.
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 NPV Old car value 4200 New machine cost -49000 Cost saving in utilities(600*30%) 180 180 180 180 180 180 180 180 180 180 180 180 180 180 180 Cost saving in maintinance(5000*50%) 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 Toal cost saving 2680 2680 2680 2680 2680 2680 2680 2680 2680 2680 2680 2680 2680 2680 2680 less - Depriciation 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 EBIT -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 ADD SALVAGE VALUE 4000 less taxes 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 EAT -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 -586.667 3413.333 add Depriciation 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 3266.667 Cash flow -44800 2680 2680 2680 2680 2680 2680 2680 2680 2680 2680 2680 2680 2680 2680 6680 Discouting Factor @7% 1 0.934579 0.873439 0.816298 0.762895 0.712986 0.666342 0.62275 0.582009 0.543934 0.508349 0.475093 0.444012 0.414964 0.387817 0.362446 Present value -44800 2504.673 2340.816 2187.678 2044.559 1910.803 1785.797 1668.969 1559.784 1457.742 1362.376 1273.249 1189.952 1112.105 1039.35 2421.139 -18941