Suppose we are thinking about replacing an old computer with a new one. The old one cost us $450,000; the new one will cost $580,000. The new machine will be depreciated straight line to zero over its 5 year life. It will probably be worth about $130,000 after five years.

The old computer is being depreciated at a rate of $90,000 per year. It will be completely written off in three years. If we don't replace it now, we will have to replace it in two years. We can sell it now for $230,000; in two years, it will probably be worth $60,000. The new machine will save us $85,000 per year in maintenance costs. The tax rate is 21 percent and the discount rate is 14 percent.

Required:

(a) Suppose we recognize that if we don't replace the computer now, we will be replacing it in two years. Should we replace it 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 hat the two investments have unequal lives).

(b) Suppose we consider only whether we should replace the computer now about what's without worrying about what's going to happen in two years. What are the relevant cash flows? Should we replace it or not? (Hint: Consider the net change in the firm's aftertax cash flows if we do the replacement.)