Suppose that a firm is considering replacing an inefficient machine with a new, more efficient one. The
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Question:
Suppose that a firm is considering replacing an inefficient machine with a new, more efficient one. The new machine will cost $200,000 and is expected to last for six years. The current one, obtained two years ago at an original cost of $120,000, could be sold for $36,000 today if it is replaced. Otherwise, it will be kept for six more years. Both machines are classified into five-year MACRS life. The new machine would allow the firm to save $45,000 in operating costs each year, thus the operating income on a before-tax basis, excluding depreciation, will increase from $20,000 to $65,000. Given 40% as the tax rate and 10% as the cost of capital, the firm needs to determine if it should proceed with the replacement.
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