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 10% rate of return on its investments. (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 $ 112,000
Cost of overhaul 150,000
Annual expected revenues generated 95,000
Annual cash operating costs after overhaul 42,000
Salvage value of old machine in 5 years 15,000

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 $ 300,000
Salvage value of old machine now 29,000
Annual expected revenues generated 100,000
Annual cash operating costs 32,000
Salvage value of new machine in 5 years 20,000

1. Determine the net present value of alternative 1.
2. Determine the net present value of alternative 2.
3. Which alternative do you recommend that management select? Explain.

Answer 1

Answer and Explanation:

According to the scenario, computation of the given data are as follow:-

a) Net Present Value of Alternative 1

Given that

Net Initial cash investment = $150,000

Rate of return on investment = 10%

Salvage value of old machine = $15,000  

Subsequent Cash Inflow is

= Expected Revenue Generated - Operating Cost After Overhaul

= $95,000 - $42,000

= $53,000

Year  Subsequent Cash Inflow($) Present Value Table  (10%) Present Value Of Cash Inflow($)

1 $53,000         0.909    $48,177

2 $53,000         0.826    $43,778

3 $53,000         0.751   $39,803

4 $53,000         0.683   $36,199

5 $68,000

(53,000+15,000) 0.621   $42,228

Total                      $210,185

   

Now

Net Present Value is

= Present Value of Cash Inflow - Present Value of Cash Outflow

= $210,185 - $150,000

= $60,185

b).Net Present Value of Alternative 2

Net initial cash investment = 300,000

Rate of return on investment = 10%

Cash Outflow is

= Expected Revenue Generated - Operating Cost

= $100,000 - $32,000

= $68,000

Year  Cash Outflow($) Present Value Table (10%) Present Value ($)

1         $68,000                   0.909                                $61,812

2         $68,000                  0.826                                $56,168

3         $68,000                  0.751                                $51,068

4          $68,000          0.683                                $46,444

5          $88,000          0.621                                $54,648

      ($68,000 + $20,000)

Add: Salvage value of old machine now        $29,000

Total value                                                         $299,140

Now

Net Present Value is

= Present Value of Cash Inflow - Present Value of Cash Outflow

= $299,140 - $300,000

= -$860

c).According to the analysis, we recommended alternative 1 for selecting by management as it contains positive net present value