Suppose we are thinking about replacing an old computer with a new one. The old one cost us $430,000; the new one will cost $465,000. The new machine will be depreciated straight-line to zero over its five-year life. It will probably be worth about $45,000 after five years.
The old computer is being depreciated at a rate of $40,000 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 $165,000; in two years, it will probably be worth $25,000. The new machine will save us $60,000 per year in operating costs. The tax rate is 38 percent and the discount rate is 11 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 only consider whether or not 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? Consider the net change in the firm’s after tax cash flows if we do the replacement.