Pilot Plus Pens is deciding when to replace its old machine. The machine's current salvage value is $1.8 million. Its current book value is $1.1 million. If not sold, the old machine will require maintenance costs of $750,000 at the end of the year for the next five years. Depreciation on the old machine is $220,000 per year. At the end of five years, it will have a salvage value of $175,000 and a book value of $0. A replacement machine costs $4.0 million and requires maintenance costs of $265,000 at the end of each year of its economic life of five years. Additional working capital of $35,000 will be required and will be fully recovered at the end of the project. Installation costs are estimated at $200,000. An engineering study to determine the best positioning of the machine on the shop floor was commissioned last year at a cost of $27,000. At the end of the five years, the new machine will have a salvage value of $600,000. It will be fully depreciated to a zero book value by the straight-line method. In five years a replacement machine will cost $3, 400,000. The company will need to purchase this machine regardless of what choice it makes today. The corporate tax rate is 40 percent and the appropriate discount rate is 8 percent. The company is assumed to earn sufficient revenues to generate tax shields from depreciation.
Should the company replace the old machine now or at the end of five years?
How would your answer change if you found out that Pilot will depreciate the new machine under a 3yr MACRS schedule? The MACRS rates from Table 4.2 are: Year 1 = 33%: Year 2 = 45%: Year 3 = 15%: Year 4 = 7%. Show you work carefully.