X Company must decide whether to continue using its current equipment or replace
ID: 2788017 • Letter: X
Question
X Company must decide whether to continue using its current equipment or replace it with new, more efficient equipment. The following information is available for the current and new equipment: Current equipment Current sales value Final sales value Operating costs $10,000 3,500 62,500 New equipment Purchase cost Final sales value Operating cost savings $47,000 7,000 9,000 Maintenance work will be necessary on the current equipment in Year 3, costing $3,000. The current equipment will last for 5 more years; the life of the new equipment is also 5 years. Assuming a discount rate of 4%, what is the net present value of replacing the current equipment?Explanation / Answer
SOLUTION
Each machine has a life of 5 years and the decision of using the current machine or buying a new one depends on which machine involves lesser cost in present value terms. Let's analyse these associated costs and recoverable machine value (sale post 5 years) for both the machines:
1. Old machine
Initial investment: NIL
Annual Operating cost: $62,500 per year for 5 years ; maintenance cost in year 3 : $ 3,000
Salvage Value: $ 3,500 (value expected to be received on sale post 5 years of operation)
2. New machine
Initial investment: $ 47,000
Annual Operating cost: $53,500 per year for 5 years ($9,000 less than the old machine)
Salvage Value: $ 7,000 (value expected to be received on sale post 5 years of operation)
Please refer below for year on year cash flows and discounted cash flows @4%.
OLD MACHINE
NEW MACHINE
ANSWER:
As the Net Present cost of buying a New Machine and operating for 5 years and selling off the old machine is $ 2,69,419 ,which is lesser than operating old machine for 5 years ($ 2,78,029), it is benefial to buy and operate new machine and sell off the old machine
Initial Investment Year 1 Year 2 Year 3 Year 4 Year 5 Operating Expenditue $0 ($62,500) ($62,500) ($62,500) ($62,500) ($62,500) Maintenance Expenditure $0 $0 ($3,000) $0 $0 Salvage Value - - - - $3,500 Total Cash flows ($62,500) ($62,500) ($65,500) ($62,500) ($59,000) Discount Factor@4% 0.962 0.925 0.889 0.855 0.822 Discounted Cash flow ($60,096) ($57,785) ($58,229) ($53,425) ($48,494) Net Present Value (NPV) of Costs ($2,78,029)Related Questions
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