Replacement Exercise

The manufacturing division in ABC Ltd. is contemplating replacing its old machine with a new
one. The machine’s current market value is $2.8 million. Its current book value is $1.6 million.
The machine incurs the following charges annually: Maintenance costs of $855,000 and
depreciation. The machine is depreciated using a straight line method and its book value will
become $0 after 5 years. At the end of 5 years it will have a salvage value of $140,000. The new
machine costs $4.5 million today and will incur annual maintenance charges of $350,000. The new
machine has an economic life of 5 years and the firm will completely depreciate the machine over
its economic life using straight-line method. The estimated salvage value of the machine at the end
of its depreciable life is $900,000. After 5 years a replacement machine will cost $3.4 million and
the firm will purchase this machine after the existing machine is fully depreciated. The firm’s
WACC is 8% and corporate tax rate is 40%. You are associated with the department as an intern
and are aware of the principles of corporate finance that will be handy for decision making in this
case. Hence, you decide to apply the concepts of capital budgeting to arrive at the right choice and
want to appraise the manager about the right decision that the firm must undertake. Show
appropriate calculations to convince the manager that you are right!