The Replacement Problem

Key Question
Jigdrel Systems Co. is thinking of replacing an extrusion press
purchased five years ago for Nu. 10,00,000. The press, which is
used in the manufacture of semiconductors, is being depreciated on a
straight line basis over a period of 10-year life to salvage value of zero.
Annual depreciation is therefore Nu. 1,00,000, and the current book
value of the old machine is Nu. 5,00,000.
The replacement extrusion press was developed by the company at a
cost of Nu. 7,50,000. It would cost Nu. 20,00,000 to have it built and
installed and would have a life of five years. The estimated salvage
value at the end of five years is Nu. 5,00,000. What is your suggestion
with regards to replacement of extrusion press to Jigdryel Systems Co. ?

Data on Jigdryel System’s Investment in a New Extrusion Press

Old Machine New Machine
Cost of Machine Nu. 10,00,000 Nu. 20,00,000
Development Cost Nu. 7,50,000
Straight –line depreciation 10 years 5 years
Annual Depreciation charge Nu. 1,00,000 Nu. 3,00,000
Depreciated Value Nu. 5,00,000 --
Salvage value ? Nu. 5,00,000
Marginal Tax Rate 35% 35%
Additional Sales Nu. 1,50,000
Net Increase in Working Capital Nu. 45,000

Additional Information

1. Net working capital to sales ratio = 30%

2. For this Question, the Sale Price of Old Asset is Nu. 7,00,000

3. Operating Cash Flows Information

The new extrusion press is expected to increase Revenue by Nu. 1,50,000 annually, it will also
reduce annual operating expenses by Nu. 1,80,000 because it requires only one operator instead
of two, is more energy efficient, and will reduce the defect rate. In year I, the annual depreciation
The Replacement Problem

charge will rise by Nu. 3,00,000 because depreciation for the new machine is Nu. 4,00,000
compared with annual depreciation of Nu. 1,00,000 for the old machine.
4. For Deprn. assume MACRS direct Incremental tax Shields. (Not Mandatory and can be
copied from Text)