Replacement Decisions Suppose we are thinking about replacing an old computer with

a new one. The old one cost us $$1\mathrm{.}4$ million; the new one will cost $$1\mathrm{.}7$ million. The

new machine will be depreciated straight$-$line to zero over its five$-$year life. It will prob$-$

ably be worth about $$325,000$ after five years.

The old computer is being depreciated at a rate of $$281,000$ per year. It will be

completely written off in three years. If we don't replace it now, we will have to replace

it in two years. We can sell it now for $$450,000$; in two years, it will probably be worth

$$130,000.$ The new machine will save us $$315,000$ per year in operating costs. The tax

rate is $22$ percent, and the discount rate is $12$ percent.

a$.$ Suppose we recognize that if we don't replace the computer now, we will be replacing

it in two years. Should we replace now or should we wait? $($Hint: What we effectively

have here is a decision either to "invest" in the old computer$-$by not selling it$-$or to

invest in the new one. Notice that the two investments have unequal lives.$)$

b$.$ Suppose we consider only whether we should replace the old computer now without

worrying about what's going to happen in two years. What are the relevant cash

flows? Should we replace it or not? $($Hint: Consider the net change in the firm's

aftertax cash flows if we do the replacement.$)$