It is being decided whether or not to replace an existing piece of equipment with a newer, more productive one that costs $80,000 and has an estimated MV of $20,000 at the end of its useful life of six years. Installation charges for the new equipment will amount to $3,000; this is not added to the capital investment but will be an expensed item during the first year of operation. MACRS (GDS) depreciation (five-year property class) will be used. The new equipment will reduce direct costs (labor, maintenance, rework, etc.) by $10,000 in the first year, and this amount is expected to increase by $500 each year thereafter during its six-year life. It is also known that the BV of the fully depreciated old machine is $10,000 but that its present fair MV is $14,000. The MV of the old machine will be zero in six years. The effective income tax rate is 40%.
a. Determine the prospective after-tax incremental cash flow associated with the new equipment if it is believed that the existing machine could perform satisfactorily for six more years.
b. Assume that the after-tax MARR is 12% per year. Based on the ERR method, should you replace the defender with the challenger? Assume e = MARR.