Your firm is considering replacing an old machine with a new machine. The new machine will cost $5 million and will produce free cash flows of $4.5 million per year for the next five years. The new machine will be depreciated on a straight-line basis to a book value of 0and will have a salvage value of $1.25 million after five years.

The existing machine currently has a book value of $1 million and can be sold today for $2 million. If left in place (i.e. if you not replace it), it will produce free cash flows of $2 million per year for five years. After five years it will have a book value of 0 and a salvage value of $0.5 million.

Should you replace the old machine with the new machine? The WACC for both machines is 10% and the firm's tax rate is 40%.

Hint: Focus on incremental cash flows (i.e. how cash flows change if you replace the machine).

Answer rating: 100% (QA)

Heres a comprehensive analysis of the machine replacement decision focusing on incremental cash flows Incremental Cash Flows Year 0 Initial cost of new machine 5000000 Proceeds from selling old machine 2000000 Taxes on sale of old machine 40 1000000 gain 400000 Net cash flow ... View the full answer