A company purchased a machine three years ago for $160,000. It is being depreciated on a straight-line basis over an eight-year life to a zero salvage value. This particular machine was purchased because the firm anticipated a high level of production that never materialized. The firm is considering selling this machine and purchasing a smaller model. It could sell this machine today for its book value of $100,000.
The smaller model costs $50,000, including installation costs, and would be depreciated on a straight-line basis over a five-year life to a zero salvage value. The smaller model will require more labor to operate and management estimates that labor costs will increase by $15,000 per year.
The firm’s income tax rate is 46 percent. Finally, this firm uses a hurdle rate (WACC) of 14 percent to evaluate replacement decisions like this one. Should the firm acquire the smaller machine?