Interstate Manufacturing is considering either replacing one of its old machines
ID: 2575977 • Letter: I
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. Cost of old machine $ 114,000 - Cost of overhaul 147,000 - Annual expected revenues generated 91,000 - Annual cash operating costs after overhaul 45,000 - Salvage value of old machine in 5 years $19,000
Alternative 2: Sell the old machine and buy a new one. The new machine is more efficient and will yield substantial operating cost savings with more product being produced and sold. Cost of new machine $ 292,000 - Salvage value of old machine now 45,000 - Annual expected revenues generated 102,000 - Annual cash operating costs 28,000 - Salvage value of new machine in 5 years 5,000
1. Determine the Net Present Value of Alternative 1
2. Determine the Net Present Value of Alternative 2
3. Which alternative should managment select?
Explanation / Answer
Answer 1.
Initial Cash Outflow = Overhaul Cost
Initial Cash Outflow = $147,000
Annual Revenue = $91,000
Annual Operating Cost = $45,000
Salvage Value at the end of Year 5 = $19,000
Annual Cash Inflows Year 1 - 4 = Annual Revenue - Annual Operating Cost
Annual Cash Inflows Year 1 - 4 = $91,000 - $45,000
Annual Cash Inflows Year 1 - 4 = $46,000
Annual Cash Inflows Year 5 = Annual Revenue - Annual Operating Cost + Salvage Value
Annual Cash Inflows Year 5 = $91,000 - $45,000 + $19,000
Annual Cash Inflows Year 5 = $65,000
NPV = -$147,000 + $46,000/1.12 + $46,000/1.12^2 + $46,000/1.12^3 + $46,000/1.12^4 + $65,000/1.12^5
NPV = $29,600.82
Answer 2.
Initial Cash Outflow = Cost of New Machine - Salvage Value of Old Machine
Initial Cash Outflow = $292,000 - $45,000
Initial Cash Outflow = $247,000
Annual Revenue = $102,000
Annual Operating Cost = $28,000
Salvage Value at the end of Year 5 = $5,000
Annual Cash Inflows Year 1 - 4 = Annual Revenue - Annual Operating Cost
Annual Cash Inflows Year 1 - 4 = $102,000 - $28,000
Annual Cash Inflows Year 1 - 4 = $74,000
Annual Cash Inflows Year 5 = Annual Revenue - Annual Operating Cost + Salvage Value
Annual Cash Inflows Year 5 = $102,000 - $28,000 + $5,000
Annual Cash Inflows Year 5 = $79,000
NPV = -$247,000 + $74,000/1.12 + $74,000/1.12^2 + $74,000/1.12^3 + $74,000/1.12^4 + $79,000/1.12^5
NPV = $22,590.57
Answer 3.
So, Alternative 1 should be selected as its NPV is higher than NPV of Alternative 2.
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