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Three years back, a machine was purchased at a cost of Rs
Three years back, a machine was purchased at a cost of Rs. 3,00,000 to be useful for 10 years. Its salvage value at the end of its estimated life is Rs. 50,000. Its annual maintenance cost is Rs. 40,000. The market value of the present machine is Rs. 2,00,000. A new machine to cater to the need of the present machine is available at Rs. 2,50,000 to be useful for 7 years. Its annual maintenance cost is Rs. 14,000. The salvage value of the new machine is Rs. 20,000. Using an interest rate of 15%, find whether it is worth replacing the present machine with the new one.
Expert Solution
You will have to invest 50,000 more for new machine after 3 years whose annual cost is 14,000 while annual cost of earlier machine installed was 40,000.
Rate of Interest = 15%
Present value is calculated as: [Annual maintenance cost / (1 + Rate of Interest)^Year]
| Year | Old machine annual maintenance cost | Present value of old machine | New machine annual maintenance cost | Present value of new machine |
| 4 | 40,000.00 | 22,870.13 | 14,000.00 | 8,004.55 |
| 5 | 40,000.00 | 19,887.07 | 14,000.00 | 6,960.47 |
| 6 | 40,000.00 | 17,293.10 | 14,000.00 | 6,052.59 |
| 7 | 40,000.00 | 15,037.48 | 14,000.00 | 5,263.12 |
| 8 | 40,000.00 | 13,076.07 | 14,000.00 | 4,576.62 |
| 9 | 40,000.00 | 11,370.50 | 14,000.00 | 3,979.67 |
| 10 | 40,000.00 | 9,887.39 | 14,000.00 | 3,460.59 |
| 109,421.74 | 38,297.61 |
Investing in new machine will save 109,421.74 - 38,297.61 = 71,124.13 in present terms
Additionally, present value of salvage received after 10 years of new machine is [20,000 / (1 + 0.15)^7] = 7,518.74
Total money you save from investing in new machine = - 50,000 + 71,124.13 + 7,518.74 = 28,642.87
Thus, this machine should be replaced with new one.
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