The Northwestern Railroad Company is thinking of replacing a locomotive that it purchased 8 years ago. At that time the projected life of the locomotive was 20 years. It cost $1,325,000 and was expected to have a salvage value of $230,000. It can currently be sold for $745,000. Maintenance costs for the old machine were $133,000 during the last year and are expected to grow at 5% per year. The new locomotive they are thinking of buying has a life of 15 years. It costs $1,640,000 and has an expected salvage value of $195,000. The maintenance costs are expected to be $96,000 during the first year and to grow at 4% thereafter. Both locomotives are expected to generate the same revenues.
The firm has a tax rate of 37%. It has profitable ongoing operations and can offset all the costs for tax purposes. It uses straight line depreciation. Assume all cash flows occur at the end of the year. The firm’s discount rate for decisions of this type is 12%. Does the old or the new locomotive have the highest equivalent annual cost? Should Northwestern replace the locomotive?
