Seaside Baking Co is considering purchase of new pastry oven. Alternative 1: Con

Question

Seaside Baking Co is considering purchase of new pastry oven. Alternative 1: Conventional oven will cost $100,000 and can be expected to last 5 years, with a salvage value of $10,000. Operating cost, e.g., electricity used, will be $22,000 per year. Maintenance Cost is will be $5,000 per year. Alternative 2: Convection oven will cost $140,000, should last 5 years, and will have a salvage value of $12,000. The operating costs will be $10,000 per year. Maintenance Cost will be a bit higher at $7,000 per year. Assume the services provided by the pastry ovens are identical; assume an interest rate of 10%. a) Compare the annual equivalent costs of the 2 alternatives. b) Make a recommendation for selection based upon equivalent costs.

Explanation / Answer

Cash flows and NPV calculations:

(discount factor = 1/(1+r)^t where r = 10% and t = the year of the cash flow). (Present value = cash flow*discount factor). (Net present value = sum of all present values).

Now, annual equivalent costs = NPV/5 year PV factor of annuity @10%

Using the PVIFA table, the factor for 5 years and 10% = 3.791

Thus, annual equivalent cost of alternative 1 = -196,142.03/3.791 = -$ 51,738.86

annual equivalent cost of alternative 2 = -196,992.32/3,791 = -$51,963.15

The annual equivalent cost of alternative 1 is less than the annual equivalent cost of alternative 2. Hence alternative 1 is better.

Alternative 1 Years 0 1 2 3 4 5 Initial cost -100,000.00 Electricity costs -22,000.00 -22,000.00 -22,000.00 -22,000.00 -22,000.00 Maintenance costs -5,000.00 -5,000.00 -5,000.00 -5,000.00 -5,000.00 Salvage value 10,000.00 Net cash flows -100,000.00 -27,000.00 -27,000.00 -27,000.00 -27,000.00 -17,000.00 10% discount factors 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209 Present values -100,000.00 -24,545.45 -22,314.05 -20,285.50 -18,441.36 -10,555.66 NPV -196,142.03 Alternative 2 Years 0 1 2 3 4 5 Initial cost -140,000.00 Electricity costs -10,000.00 -10,000.00 -10,000.00 -10,000.00 -10,000.00 Maintenance costs -7,000.00 -7,000.00 -7,000.00 -7,000.00 -7,000.00 Salvage value 12,000.00 Net cash flows -140,000.00 -17,000.00 -17,000.00 -17,000.00 -17,000.00 -5,000.00 10% discount factors 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209 Present values -140,000.00 -15,454.55 -14,049.59 -12,772.35 -11,611.23 -3,104.61 NPV -196,992.32

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