Problem 3

Precision Instruments operates a machine that was purchased at a cost of $580,000 three years ago. Its current market value is $340,000. An improved version of the machine is now available for $600,000. The firm has spent $20,000 on a study examining the feasibility of replacing the old machine with the new machine and found that the new machine is capable of performing the same functions as the old one. Both machines belong to CCA class 10 (CCA rate = 30%) and have an expected remaining useful life of four years. While the older machine will be worth only $60,000 by that time, the new machine can be sold for $250,000 in four years. Management believes that the company will have other class 10 assets in four years when the new equipment will be sold. The cost of operating the old machine is expected to be $100,000 next year (i.e. t = 1) with this cost increasing at 4% per year over the next three years. Management estimates that the cost of operating the new machine will be $50,000 in its first year of operation (i.e. t = 1) and will increase at the same rate as the cost for the old machine. In addition, the more efficient new machine will immediately reduce the amount of net working capital (NWC) required by $30,000. The firms marginal corporate tax rate is 35% and the required rate of return is 12%. Should the firm replace the machine?