Interstate Manufacturing is considering either replacing one of its old machines

Question

Interstate Manufacturing is considering either replacing one of its old machines with a new machine or having the old machine overhauled. Information about the two alternatives follows. Management requires a 12% rate of return on its investments. Use the (PV of $1, FV of $1, PVA of $1, and FVA of $1) (Use appropriate factor(s) from the tables provided.) Alternative 1: Keep the old machine and have it overhauled. If the old machine is overhauled, it will be kept for another five years and then sold for its salvage value.

Explanation / Answer

1) NPV of alternative 1 Initial cash investment 146000 I = 12% = 0.12 Year Subsequent cash inflow X Table Factor = Present value (outflow) 1 61000 X 0.8929 = 54466.90 2 61000 X 0.7972 = 48629.20 3 61000 X 0.7118 = 43419.80 4 61000 X 0.6355 = 38765.50 5 80000 X 0.5674 = 45392.00 Total 230673.40 Less Initial cash investment 146000.00 NPV 84673.40 Subsequent cash inflow 1 to 4 (108000 - 47000) = 61000 5 (61000 + 19000) 2) NPV of alternative 2 Initial cash investment (net) (290000 - 42000) 248000 I = 12% = 0.12 Year Subsequent cash inflow X Table Factor = Present value (outflow) 1 66000 X 0.8929 = 58931.40 2 66000 X 0.7972 = 52615.20 3 66000 X 0.7118 = 46978.80 4 66000 X 0.6355 = 41943.00 5 74000 X 0.5674 = 41987.60 Total 242456.00 Less Initial cash investment 248000.00 NPV -5544.00 Subsequent cash inflow 1 to 4 (86000 - 20000) = 66000 5 (66000 + 8000) = 74000 3) The management should select the 1st alternative as it gives a higher positive NPV

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