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 $130000 and is currently valued at $50000. It is expected to last a further 8 years at which time it would be buried on the company%u2019s property
for a flat fee of $2000 paid to the city of Montreal.
The new machine according to the brochure sent over by the saleswoman has a manufacturer%u2019s suggested retail price of $275000
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 $1000. This new machine is expected to last 8 years at which time it could be sold for $15000. 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 $47000. Sonny Tubbs a highly experienced analyst has
submitted an estimated 50% above Crocket%u2019s. Johnson feels that Tubbs%u2019 estimate is more reliable but that Crocket%u2019s estimate has considered some
things left out by Tubbs. In fact Johnson feels that Tubbs%u2019 estimate has a 75% chance of being right while Crocket%u2019s 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%u2019s 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?