A machine purchased three years ago for $720,000 has a current book value using straight-line depreciation of $400,000; its operating expenses are $60,000 per year. A replacement machine would cost $480,000, have a useful life of nine years, and would require $26,000 per year in operating expenses.

A machine purchased three years ago for $720,000 has a current book value using straight-line depreciation of $400,000; its operating expenses are $60,000 per year. A replacement machine would cost $480,000, have a useful life of nine years, and would require $26,000 per year in operating expenses. It has an expected salvage value of $130,000 after nine years. The current disposal value of the old machine is $170,000; if it is kept 9 more years, its residual value would be $20,000.

Required
Calculate the total costs in keeping the old machine and purchase a new machine. Should the old machine be replaced?

Explanation

The original cost and book value of the old machine are different measures of the same sunk cost and are therefore not relevant. The opportunity cost of using the old machine in future accounting periods is its current market value less its future salvage value ($170,000 − $20,000 = $150,000). Similarly, using the new machine would cost $350,000 ($480,000 − $130,000). The relevant (avoidable) cost of operating each machine for nine years is shown below:
 

Decision	Keep Old Machine			Purchase New Machine
Opportunity cost	$	150,000
Purchase price less salvage					$	350,000
Operating costs		540,000				234,000
Total costs	$	690,000			$	584,000

Since the cost of the new machine is less than the old, the old machine should be replaced. Stated alternatively, by operating the new machine, the cost of the old is avoided. To avoid as much cost as possible, the old machine should be replaced.

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