Question

Problem 24-4A Computing net present value of alternate investments LO P3 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. 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 $ 108,000 Cost of overhaul 156,000 Annual expected revenues generated 93,000 Annual cash operating costs after overhaul 52,000 Salvage value of old machine in 5 years 22,000 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 $ 307,000 Salvage value of old machine now 39,000 Annual expected revenues generated 113,000 Annual cash operating costs 22,000 Salvage value of new machine in 5 years 11,000

Answer 1

Net present value = present value of cash inflows – present value of cash outflows

Alternative 1: Overhaul

= -156,000 +(93,000-52,000)*PVAF(10%, 5 years) + 22,000*PVF(10%, 5 years)

= -156,000 + 41,000*3.791 + 22,000*0.621

= $13,093

Alternative 2: New Machine

NPV = -307,000 + 39,000 + (113,000-22,000)*PVAF(10%, 5 years) + 11,000*PVF(10%, 5 years)

= -307,000 + 39,000 + 91,000*3.791 + 11,000*0.621

=$83,812

Since new machine has higher NPV, it should be selected

Note: Cost of old machine is not relevant for decision making since it has already been incurred and hence sunk cost.