Question

Interstate Manufacturing is considering either overhauling an old machine or replacing it with a new machine. Information about the two alternatives follows. Management requires a 10% rate of return on its investments.
Alternative 1: Keep the old machine and have it overhauled. This requires an initial investment of $150,000 and results in $50,000 of net cash flows in each of the next five years. After five years, it can be sold for a $15,000 salvage value.
Cost of old machine $111,000
Cost of overhaul 158,000
Annual expected revenues generated 106,000
Annual cash operating costs after overhaul 43,000
Salvage value of old machine in 5 years 16,000
Alternative 2: Sell the old machine for $29,000 and buy a new one. The new machine requires an initial investment of $300,000 and can be sold for a $20,000 salvage value in five years. It would yield cost savings and higher sales, resulting in net cash flows of $65,000 in each of the next five years.
Cost of new machine $291,000
Salvage value of old machine now 34,000
Annual expected revenues generated 94,000
Annual cash operating costs 22,000
Salvage value of new machine in 5 years 15,000
Required:
1. Determine the net present value of alternative 1.
2. Determine the net present value of alternative 2.
3. Which alternative should management select based on net present value?

Answer 1

1. The net present value of Alternative 1 is $90,755.

2. The net present value of Alternative 2 is $14,355 with the sale proceeds of the old machine.

3. Based on the net present value, Interstate Manufacturing should overhaul the old machine instead of replacing it with the new one.

Data and Calculations:

Required rate of return = 10%

                                                           Alternative 1    Alternative 2

Cost of old machine                               $111,000         ($29,000)

Cost of overhaul                                     158,000        $300,000

Expected annual revenues                   106,000             94,000

Expected annual operating costs          43,000             22,000

Net cash flows for 5 yrs                        63,000             72,000

Salvage value after 5 yrs                        16,000             20,000

PV annuity factor of 10% for 5 years = 3.7908

PV factor of 10% for 5 years = 0.6209

                                                           Alternative 1    Alternative 2

PV value of annual net cash flows     238,820           272,937

PV value of Salvage value                      9,935              12,418

Present value of cash inflows          $248,755        $285,355

Cost of overhaul/Investment             (158,000)       (300,000)

Proceeds from the sale of old machine                     29,000

Net present value                              $90,755           $14,355

Thus, based solely on the net present values of alternatives 1 and 2, Interstate Manufacturing should overhaul the old machine (alternative 1) because it yields a greater net present value than alternative 2.

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