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Rhule Company wants to replace an existing machine with a new one which will cost $40 million dollars to purchase. The old machine was purchased

Rhule Company wants to replace an existing machine with a new one which will cost $40 million dollars to purchase. The old machine was purchased 5 years ago for $25 million dollars, and was being depreciated straight line to a zero salvage value over its ten year life. The old machine can be sold today for $15 million dollars. The new machine is expected to be depreciated straight line over its ten year economic life to a zero salvage value. It is assumed that it could be sold at the end of the year ten for $1.5 million. Rhule expects to increase the investment in net working capital (NWC) by $1.5 million, if the new machine is purchased. The NWC will be recovered at the end of the projects life. The acquisition of the new machine would increase sales by $8 million per year for ten years, and operating expenses (excluding depreciation) would also increase by $2 million per year. The company has a marginal tax rate of 20%, and a cost of capital of 10%.

Should the old machine be replaced? Rhule is concerned that the cost of capital could be off 300 basis points. Is his concern justified? Explain.

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