Replacement Project

See Through Imaging Center, Inc. acquired an MRI machine five years ago for $480,000. The tax laws at the time permitted straight-line depreciation over eight years with the salvage value of $100,000. The new machines purchased today can be depreciated straight line over five years with the same salvage value of $100,000. The old machine has not performed well, and management is considering replacing it with a new one that will cost $720,000. If the new machine is purchased, it is estimated that the old one can be sold for $200,000. The quoted costs include all freight, installation, and setup.

The MRI machine requires two technicians, each of whom earns $70,000 a year including all benefits and payroll costs. The new machine is more efficiently designed and will require only one operator earning the same amount.

The old machine has the following history of maintenance cost and significant downtime:

Year 1 2 3 4 5

Hours down 40 60 100 130 128

Maintenance warranty $10 $35 $42 $45

expense (in $000's)

Downtime of the machine is a major inconvenience. The managers estimate that every hour of downtime costs the company $700.

The makers of the replacement machine have said that See Through Imaging Center will spend about $15,000 a year maintaining the MRI machine and that an average of 40 hours downtime a year should be expected. During the first year the maintenance is free.

The new machine is expected to produce higher quality output than the old one. The result is expected to be better customer satisfaction and possibly more referrals in the future. Management would like to include some benefit for this effect in the analysis, but is unsure of how to quantify it.

Assume See Through Imaging Center Inc.s marginal tax rate is 35%, and that the company is currently profitable so that changes in taxable income result in tax changes at 35% whether positive or negative. Assume any gain on the sale of the old machine is also taxed at 35%, since corporations dont receive favorable tax treatment on capital gains.

Estimate the incremental cash flows over the next five years associated with buying the new machine. Calculate the NPV and IRR and recommend what to do assuming 11% cost of capital.

Also, not that you will have to make certain assumptions regarding the data. Not all is certain, as is usually the case in real life.