Replacement decisions , Corporate Finance

Your boss is trying to figure out when to replace an important piece of machinery in your main production facility.  The Siemens NR550, costs $5.45 million brand new and generally lasts about 15 years before needing to be replaced (CCA Rate = 15%).  The currently installed version was put in place 5 years ago.  Since the product being produced will be obsolete in 10 years, management had not planned on replacing the NR550 (though the asset pool would remain open as a number of other projects are underway which involve similar systems).  The salvage value on the NR550 today would be $2.5 million, or $1.5 million in year 10.

Last week, Siemens offered an upgrade to the current system, the NR600, which will cost $5 million and do the same job as the NR550 for the remaining life of the production facility.  At the moment, the NR600 is brand new so its price is higher than it is expected to be in the future but the annual cost savings would be substantial.  If installed, the NR600 is expected to reduce operating costs in the production facility by $1,200,000, pre-tax, every year.  Its CCA rate is 15% and its salvage value is expected to be $535,000.  Your firm's cost of capital is estimated at 14% and its tax rate is 30%

Should the NR550 be replaced?

(Hint: to correctly value the remaining CCA tax shield for the NR550, use the remaining UCC of $2,631,564 instead of its purchase price and ignore the half-year rule as these tax shields have already been used.)

Posted Date: 2/23/2013 3:11:51 AM | Location : United States

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