Miami Vice Inc., a manufacturer of processed rice products, is considering the replacement of one of its milling machines. Ron Johnson, vice president finance, has compiled all available data concerning the old machine and the one to replace it. The old machine was purchased 3 years ago at a capital cost of $130,000 and is currently valued at $50,000. It is expected to last a further 8 years at which time it would be buried on the companys property for a flat fee of $2,000 paid to the city of Montreal.
The new machine, according to the brochure sent over by the saleswoman, has a manufacturer s suggested retail price of $275,000, including installation and transportation. Johnson has been told however that Miami Rice could obtain the machine at 15% discount but would have to pay a document preparation fee of $1,000. This new machine is expected to last 8 years at which time it could be sold for $15,000. Thomas Michael Philip, plant engineer, has suggested that the new machine not be sold at the end of 8 years but that it is kept as a spare machine to be used in the event of the breakdown of another machine. Johnson thinks this is an excellent idea.
Johnson has received two sets of cash flow estimates concerning the replacement of the old machine. One set of estimates, submitted by Ricardo Crocket, a very junior financial analyst at the company, indicates net pre-tax annual cash flows of $47,000. Sonny Tubbs, a highly experienced analyst, has submitted an estimated 50% above Crocket s. Johnson feels that Tubbs estimate is more reliable but that Crocket s estimate has considered some things left out by Tubbs. In fact, Johnson feels that Tubbs estimate has a 75% chance of being right, while Crocket s estimate has only a 25% chance of being right.
Both the old and new milling machines belong to the class 2 asset pool which has a declining balance CCA rate of 15%. The company has a policy of balance in class 2 will always be positive and that there will always be assets remaining in the class. The firm s cost of capital is 10% and its tax rate is 40%. A bank loan arranged at the local bank would cost the company 12% per annum. If the company took out this loan, its leverage would be higher.
Question: Should the old milling machine be replaced?