Service Systems is considering the replacement of a piece of equipment that was purchased 3 years ago for $60,000 and is generating a before-tax cash flow of $15,000 per year. The equipment is being depreciated by the straight-line method over an 8-year period. If sold today it would bring $18,000; its estimated resale value if kept for 5 more years is $10,000. The new piece of equipment costs $75,000 and will require installation-related expenses of $8,000. The new machine has a 5-year economic life, and it will generate a before-tax cash flow of $30,000 per year during that period. This new machine will be depreciated by the straight-line method over its 5- year life. At the end of the 5-year period, the new machine will have an estimated resale value of $20,000. The firm currently faces a 40% tax rate, and the cost of capital is 14%.
a. You, as a financial analyst for the firm, have been assigned the responsibility of deciding whether Service Systems should keep or replace the existing system. What is your recommendation? Show your work.
b. In presenting your recommendation, you mention that a replacement capital budgeting decision can be broken down into its separate components. These components are: (1) Should the new project be accepted? and (2) should the existing project be kept or abandoned? Thus,
NPVReplacement = NPVNew – NPVKeep or Abandon
Your boss does not believe you and challenge you to prove it. In order to do so, proceed as follows: First, take only those cash flows that would exist for the new equipment in (a). This is simply the expansion project. Calculate the NPV for the new equipment. Then take the remaining cash flows that involve keeping the old equipment for 5 more years versus abandoning it today. Calculate the keep-versus-abandon decision. Now, use these figures to prove the point to your boss. (Hint: Your answer should match the one in (a)). Show your work.