Week 12 Homework

EPOM407/EECS407
1.
Week 12 Homework
Park Problem 12.5 (25 points)

A firm is considering the replacement of a 2,000 lb capacity pressing machine. The machine was purchased five
years ago at a cost of $22,000. The machine was originally expected to have a useful life of 10 years and a
$2,000 estimated salvage value at the end of that period. However, the machine has not been dependable and is
frequently out of service while awaiting repairs. The maintenance expenses of the pressing machine have been
rising steadily and currently amount to about $5,000 per year. The machine could be sold now for $6,000. If
retained, the machine will require an immediate $2,500 overhaul to keep it in operable condition. This overhaul
will neither extend the originally estimated service life nor increase the value of the machine. The updated
annual operating costs, engine overhaul cost, and market values over the next five years are estimated as
follows:
N
-5
-4
-3
-2
-1
0
1
2
3
4
5
O&M
Depreciation
$5000
$5500
$6000
$6500
$7500
$2858
$4898
$3498
$2500
$1784
$1786
$1840
$892
$0
$0
Engine Overhaul
Market Value
$2500
$6000
$4500
$3500
$3000
$2500
$2000
$3000
A drastic increase in operating costs during the fourth year is expected as a result of another overhaul, which
will be required in order to keep the machine in operating condition. The firm's MARR is 15%.
(a) If the machine is to be sold now, what will be its sunk cost?
(b) What is the opportunity cost of not replacing the machine now?
(c) What is the equivalent annual cost of owning and operating the machine for two more years?
(d) What is the equivalent annual cost of owning and operating the machine for five more years?
2.
(25 points) An asset is purchased for $350,000. Its O&M costs are $50,000 in the first year and are expected
to grow 25% each year through its maximum service life of five years. The salvage value of the asset drops
30% after the first year and an additional 10% each year thereafter. If the interest rate is 15%,
(a) What is the economic life of the asset?
(b) If an asset currently owned is 3-years-old, should it be kept or replaced? If kept, for how long? Do this
using the marginal cost analysis.
(c) Re-solve part (b), assuming that the asset is needed to be service for only four more periods. Do this using
the EAC method.
(d) Reconsider the above asset again, but assume that a superior challenger is available which costs $360,000.
However, O&M costs for the challenger start at $40,000 and increase 15% each year, while the salvage
value declines 10% each period. The challenger also has a maximum service life of five years.
(i) If this asset is the only challenger for the foreseeable future, when should the three-year-old asset from
above be replaced, assuming an infinite horizon? Use the EAC method.
(ii) Re-solve part (i) if the horizon is four years. Use the PW method.
3. Park Problem 12.8 and 12.26 (25 points)

A local hospital purchased a digital image-processing machine three years ago ata cost of $45,000. The machine
had an expected life of eight years at the time of purchase and an expected salvage value of $5,000 at the end of
the eight years. However, the old machine has been slow at handling the increased business volume, so
management is considering replacing it. A new machine can be purchased for $75,000, including installation
costs. Over its five-year life, the new machine will reduce cash operating expenses by $33,000 per year. Sales
are not expected to change. At the end of its useful life, the new machine is estimated to be worthless. The old
machine can be sold today for $10,000. The hospital's interest rate for project justification is known to be 10%.
The hospital does not expect a better machine (other than the current challenger) to be available for the next five
years. Assume that the economic service life for the new machine and the remaining useful life for the old
machine are both five years.
(a) Determine the cash flows associated with each option (keeping the defender versus purchasing the
challenger).
(b) Should the hospital replace the defender now?
(c) Rework parts (a) and (b) assuming the following additional information:
The old machine will be depreciated according to the straight-line method for the remaining useful life.
The new machine will be depreciated according to a seven-year MACRS.
The income tax rate is 35%, and the after-tax MARR is 12%.
4. Park Problem 12.13 and 12.28 (25 points)

A firm is considering replacing a machine that has been used for making a certain kind of packaging material.
The new machine will cost $31,000 installed and will have an estimated economic life of 10 years, with a
salvage value of $2,500. Operating costs are expected to be $1,000 per year throughout its service life. The
machine currently in use had an original cost of $25,000 four years ago, and its service life (physical life) at the
time of purchase was estimated to be seven years, with a salvage value of $5,000. This machine has a current
market value of $7,700. If the firm retains the old machine, its updated market values and operating costs for the
next four years will be as follows:
Year
End
0
1
2
3
4
Market
Value
$7,700
$4,300
$3,300
$1,100
$0
Book
Value
$7,809
$5,578
$3,347
$1,116
$0
Operating
Costs
$3,200
$3,700
$4,800
$5,850
The firm's minimum attractive rate of return is 12%.

(a) Working with the updated estimates of market values and operating costs over the next four years,
determine the remaining useful life of the old machine.
(b) Determine whether it is economical to make the replacement now.
(c) If the firm's decision is to replace the old machine in part (b), then when should the replacement occur?
(d) Rework the above with the following additional information:
The current book value of the old machine is $7,809. The anticipated book values for the next four years
are as follows: year one: $5,578; year two: $3,347; year three: $1,116; and year four: $0.
The new machine will be depreciated under a seven-year MACRS class.
The company's marginal tax rate is 35%, and the firm uses an after-tax MARR of 10%.

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EPOM407/EECS407

Park Problem 12.5 (25 points)

3. Park Problem 12.8 and 12.26 (25 points)

4. Park Problem 12.13 and 12.28 (25 points)

The firm's minimum attractive rate of return is 12%.

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