Replacement Decisions Suppose we are thinking about replacing an old computer with a new one. The old one cost us €650,000; the new one will cost €780,000. The new machine will be depreciated straight-line to zero over its five-year life. It will probably be worth about €150,000 after 5 years.

The old computer is being depreciated straight-line at a rate of €130,000 per year. It will be completely written off in 3 years. If we don’t replace it now, we shall have to replace it in 2 years. We can sell it now for €210,000;

in 2 years, it will probably be worth €60,000. The new machine will save us €145,000 per year in operating costs. The tax rate is 38 per cent, and the discount rate is 12 per cent.

(a) Suppose we recognize that, if we don’t replace the computer now, we shall be replacing it in 2 years.
Should we replace now or should we wait? (Hint:
What we effectively have here is a decision either to invest in the old computer (by not selling it) or to invest in the new one. Notice that the two investments have unequal lives.)

(b) Suppose we consider only whether we should replace the old computer now without worrying about whats going to happen in 2 years. What are the relevant cash flows? Should we replace it or not? (Hint: Consider the net change in the firm’s after-tax cash flows if we do the replacement.)