eBook

Overton Clothes Inc. is considering the replacement of its old, fully depreciated knitting machine. Two new models are available: (a) Machine 171-3, which has a cost of $177,000, a 3-year expected life, and after-tax cash flows (labor savings and depreciation) of $88,000 per year; and (b) Machine 356-6, which has a cost of $344,000, a 6-year life, and after-tax cash flows of $99,800 per year. Assume that both projects can be repeated. Knitting machine prices are not expected to rise because inflation will be offset by cheaper components (microprocessors) used in the machines. Assume that Overtons WACC is 11%. Using the replacement chain and EAA approaches, which model should be selected? Why?

Both new machines have positive NPVs; hence the old machine should be replaced. Further, since its NPV is greater with the replacement chain approach and its EAA is higher than Model -Select-171-3356-6 , choose Model -Select- (171-3, 356-6).