A special-purpose milling machine was purchased four years ago for $20,000. It was estimated at that time that this machine would have a life of 10 years, a salvage value of $1,000, and a cost of removal of $1, 500. These estimates are still good. This machine has annual operating costs of $2,000, and its current book value is $13,000 (based on "alternative MACRS, " a straight-line depreciation with a half-year convention with zero salvage value). If the machine is retained for its entire 10-year life, the remaining annual depreciation schedule would be $2,000 for years 5 through 10. A new machine that is more efficient will reduce operating costs to $1,000, but it will require an investment of $12,000. The life of the new machine is estimated to be six years with a salvage value of $2,000. The new machine would fall into the five-year MACRS property class. An offer of $6,000 for the old machine has been made, and the purchaser would pay to removal of the machine. The firm's marginal tax rate is 40%, and its required minimum rate of return is 10%.
(a) What incremental cash flows will occur at the end of years 0 through 6 as a result of replacing the old machine? Should the old machine be replaced now?
(b) Suppose that the annual operating costs for the old milling machine would increase at an annual rate of 5% over the remaining service life of the machine. With this change in future operating costs for the old machine, would the answer in part (a) change?
(c) What is the minimum salvage value for the old machine at the year 0 so that both alternatives are economically equivalent?