4 Questions
Calculate the annual depreciation expense for the old machine using the straight-line method.
The annual depreciation expense for the old machine can be calculated using the formula: $\text{Depreciation Expense} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life}}$. Substituting the given values, we get: $\text{Depreciation Expense} = \frac{1200000 - 0}{4} = $300,000 per year.
Calculate the annual cash flow associated with the old machine.
The annual cash flow associated with the old machine is the difference between the variable costs and the depreciation expense. Using the given variable cost of $1,500,000 per annum and the depreciation expense of $300,000 per year, the annual cash flow is $1,200,000.
Calculate the net present value (NPV) of replacing the old machine with the new machine.
The NPV can be calculated using the formula: $NPV = -Initial Cost + \frac{Annual Cash Flow}{(1 + r)^n} + \frac{Salvage Value}{(1 + r)^n}$, where r is the discount rate and n is the year. Substituting the given values, the NPV of replacing the old machine with the new machine is: $NPV = -2500000 + \frac{600000}{(1 + 0.10)^1} + \frac{1000000}{(1 + 0.10)^5}$.
Based on the calculated net present value (NPV), should the company replace the old machine with the new machine?
Based on the calculated NPV, if the NPV is positive, then the company should replace the old machine with the new machine. If the NPV is negative, then the company should not replace the old machine. Therefore, the decision to replace the machine depends on the calculated NPV.
Study Notes
Should Tarun Ltd Replace the Machine?
- Tarun Ltd's machine has a book value of $1,200,000 with a 4-year estimated useful life.
- The machine can be sold today for $200,000 and will have no salvage value at the end of the 4th year.
- They plan to replace the machine with a new one costing $2,500,000.
- Variable cost for the old machine is $1,500,000 per year, while the new machine's variable cost is expected to be $600,000 per year.
- The new machine has a 5-year life and a salvage value of $100,000.
- The company uses the straight-line method of depreciation.
- The corporate tax rate is 40%.
- The company expects a minimum return of 10% per annum.
- The decision revolves around whether the machine should be replaced.
- The old machine's annual depreciation is $300,000.
- The new machine's annual depreciation is $480,000.
- The net present value and internal rate of return should be calculated to make a well-informed decision.
Capital Budgeting and Replacement Analysis Quiz: Test your knowledge on evaluating the replacement of an old machine with a new one. Explore concepts such as book value, salvage value, variable costs, and the decision-making process for capital investments.
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