In Chapter 12, Brandt-Quigley’s appliance control computer project was used to show
how an expansion project is analyzed. All companies, including this one, also make
replacement decisions, and the analysis relating to replacements is somewhat different
from that for a new project analysis because the cash flows from the old asset must be
is illustrated with another BQC example, this time
A lathe for trimming molded plastics was purchased 10 years ago at a cost of $7,500.
The machine had an expected life of 15 years when it was purchased, and management
originally estimated, and still believes, that the salvage value will be zero at the end of the
15-year life. The machine is being depreciated on a straight-line basis; therefore, its annual
depreciation charge is $500, and its present book value is $2,500.
$12,000 (including freight and installation), and, over its five-year life, it will reduce labor
and raw materials usage sufficiently to cut annual operating costs from $9,000 to $4,000.
This reduction in costs will cause before-tax profits to rise by $9,000
It is estimated that the new machine can be sold for $2,000 at the end of five years;
this is its estimated salvage value. The old machine’s actual current market value is
$1,000, which is below its $2,500 book value. If the new machine is acquired, the old lathe
will be sold to another company rather than exchanged for the new machine. The
company’s marginal federal-plus-state tax rate is 40 percent, and the replacement project
is of slightly below-average risk. Net operating working capital requirements will also
increase by $1,000 at the time of replacement. By an IRS ruling, the new machine falls into
the 3-year MACRS class, and, since the cash flows are relatively certain, the project’s cost
of capital is only 11.5 percent versus 12 percent for an average-risk project. Should the
replacement be made?
Table 12B-1 shows the worksheet the company uses to analyze replacement projects.
This spreadsheet is part of the spreadsheet model developed for this chapter. Click on the
“Replacement Analysis” tab at the bottom of the chapter model to view the replacement
analysis model. Input data are shown in Cells E6 through E13, and the MACRS 3-year
depreciation schedule is given in the range of cells from A16 through E18. Each spread-
sheet row is numbered, and a row-by-row description of the table follows.
The top section of the table, Rows 23 through 26, sets forth the cash flows which
occur when the investment is made (approximately at t
0). Row 23 shows the purchase
price of the new machine, including installation and freight charges. Because it is an out-
flow, it is negative.