The Maintenance Engineer wants to buy a new generator for $1500 which has an exp

Question

The Maintenance Engineer wants to buy a new generator for $1500 which has an expected useful life of 3 years, annual maintenance cost of $250, and no salvage value. This is being considered to replace an underperforming current generator bought from China which costs $2500, but is requiring $750/yr in maintenance costs and will also have no salvage value at the end of 3 yrs. The hurdle rate is 8%. Should we approve the purchase of a more reliable new generator (10 points)? Please draw a Cash Flow Diagram and calculate the best financial alternative using whatever method you prefer (10 points). Then provide some comments as to what other factors may influence the best business decision. (14 points)

Explanation / Answer

1. New Generator will be approved if the Present Value of Cashout flows from purchasing such new generator will be less than the Present value of cash outflows from old purchased generator.

Calculation of Present Value of Cash outflows from purchasing new generator

Particulars

Amount (In $)

(A)

Time(n)

Present Value Factor (1/ (1.08)n), i=11%

(B)

Present Value Amount (In $)

(A x B)

Cash Outflows:

Purchase of Generator

1,500

0

1

1,500

Annual Maintenance Cost

250

1-3

2.5771

644.275

Total Present Value of CASH OUTFLOWS

2,144.275

Calculation of Present Value of Cash outflows from current generator

Particulars

Amount (In $)

(A)

Time(n)

Present Value Factor (1/ (1.08)n), i=11%

(B)

Present Value Amount (In $)

(A x B)

Cash Outflows:

Purchase of old Generator (See Note 1)

0

0

1

0

Annual Maintenance Cost

750

1-3

2.5771

1,932.825

Total Present Value of CASH OUTFLOWS

1,932.825

NOTE 1: Purchase value of old generator is not taken into account while calculating the present value cash outflows because the same has already been incurred and it is not a relevant cost. Maintenance cost is relevant as the can be avoided if new generator is purchased.

In the given case, Present Value of Cash outflows from new generator is more than the Present value of Cash outflows from old generator and therefore, purchase of new reliable generator is nor recommended.

NOTE: In the question, tax rate applicable is not given and therefore same is not considered for solving the question. If tax rate would have been given, then we will have to calculate the present value of tax savings from depreciation on both generator and such tax saving present value amount will be deducted from the present value of cash outflows of respective generators. This is one of the factor that influence the best business decisions as asked in the third part of the question.

Particulars

Amount (In $)

(A)

Time(n)

Present Value Factor (1/ (1.08)n), i=11%

(B)

Present Value Amount (In $)

(A x B)

Cash Outflows:

Purchase of Generator

1,500

0

1

1,500

Annual Maintenance Cost

250

1-3

2.5771

644.275

Total Present Value of CASH OUTFLOWS

2,144.275

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