Question

"Consider the following two options related to one of the old but special machine tools in your machine shop. -Option 1: You continue to use the old machine tool that was bought four years ago for $12,000. It has been fully depreciated but can be sold for $1,800. If kept, it could be used for 3 more years with proper maintenance and with some extra care. No salvage value is expected at the end of 3 years. The maintenance costs would run $10,000 per year for the old machine tool. -Option 2: You purchase a brand-new machine tool at a price of $13,000 to replace the present equipment, it also has an expected economic life of 3 years and will have a salvage value of $2,000 at the end of that time. With the new machine tool, the expected operating and maintenance costs (with the scrap savings) amount to $2,000 each year for 3 years. What is the DIFFERENCE IN PRESENT WORTH between the two alternatives at an interest rate of 13%? Enter your answer as a positive number."

Answer 1

Ans:

OPTION-1:

Here, suppose he uses the equipment for 3 years,

then present worth of alternative :

10000/(1+r) + 10000/(1+r)^2 + 10000/(1+r)^3

=> (-) $23611.5260

OPTION-2:

Availing this option means we are replacing the exisiting old equipment. So, we sell it at $1800.(+ve cash inflow)

Now, total cost associated =

$13000 + 2000/(1+r) + 2000/(1+r)^2 + 2000/(1+r)^3 - 2000/(1+r)^3

(since , salvage value at end of 3 years is 2000, so we need to discount that too)

=> (-) $16336.205

Present worth = $1800 - $16336.205 = (-)$14536.205.

Thereby difference between the two =

Option2 - Option1 = (-)$14536.205. + $23611.5260

=> $9075.321 .