AFB,Inc.is considering replacing an old machine with a new one.Two months ago their chief engineer completed a training seminar on the new machine's operation and efficiency.The $3,000 cost for this training session has already been paid.If the new machine is purchased,it would require $7,000 in installation and modification costs to make it suitable for operation in the factory.The old machine originally cost $80,000 five years ago and is being depreciated by $10,000 per year.The new machine will cost $100,000 before installation and modification.It will be depreciated by $12,000 per year.The old machine can be sold today for $12,000.The marginal tax rate for the firm is 40%.Compute the relevant initial outlay in this capital budgeting decision.

Question

Quizplus · Accepted Answer

To determine the relevant initial outlay, we need to calculate the following:

1. The cost of the new machine: $100,000
2. Installation and modification costs: $7,000
3. After-tax proceeds from selling the old machine: $7,200 ($12,000 x (1-0.40))
4. Tax savings from depreciation on the new machine: $4,800 ($12,000 x 0.40)

Therefore, the relevant initial outlay is:
$100,000 + $7,000 - $7,200 - $4,800 - $3,000 = $92,000

Since the relevant initial outlay is higher than the cost of keeping the old machine, which is $80,000 - $10,000 = $70,000 (depreciated value after five years), the best choice is to keep the old machine. The cost savings can be used for other investments or operational expenses.

AFB,IncIs Considering Replacing an Old Machine with a New One