Delafono is evaluating the option of replacing an old pasta-making machine that is expected not to last more than two years. During that time, the machine is expected to generate a cash inflow of 20,000 per year. It could be replaced by a new machine at a cost of 150,000. The new machine is more efficient than the current one, and as a result, it is expected to generate a net cash flow of 75,000 per year for three years. The management of Delafono is wondering whether to replace the old machine now or wait another year. Delafono’s cost of capital is 10 per cent.
Required:
1. Assume that the current resale value of the old machine is zero and that the new machine will also have a zero resale value in the future. What is the annual equivalent cash flow of using the new machine?
2. What should the management of Delafono do? Explain.