Question

A collection company has an antiquated high-capacity printer that needs to be updated. The company is faced with two alternatives: the system either can be overhauled or replaced with a new system. The following data has been gathered concerning these two alternatives (ignore income taxes).

Overhaul Present Purchase New System System Purchase cost when new $ 300,000 $ 400,000 Accumulated depreciation $ 220,000 Overhaul costs needed now $ 250,000 Annual cash operating costs $ 120,000 $ 90,000 Salvage value now $ 90,000 Salvage value in ten years $ 30.000 $ 80,000 Working capital required $ 50.000

The company uses a 10% discount rate and the total-cost approach to capital budgeting analysis. The working captial required under the new system would be released for use elsewhere at the conclusion of the project. Both alternatives are expected to have a useful life of ten years.

Please use excel format with formulas or explained solutions.

1. Calculate the net present value for each alternative.
2. Calculate the profitability index for each alternative.
3. Would you suggest that the company continue with one of the alternatives? If so, which alternative and why?

Answer 1

Question 1.

Present System		Discounted Rate	10.00%
Particulars	Amount	Year
Book Value	$                       -80,000.00	0	$       -80,000.00
Overhaul Cost	$                   -2,50,000.00	0	$    -2,50,000.00
Cash Operating Cost	$                   -1,20,000.00	1	$    -1,09,090.91
Cash Operating Cost	$                   -1,20,000.00	2	$       -99,173.55
Cash Operating Cost	$                   -1,20,000.00	3	$       -90,157.78
Cash Operating Cost	$                   -1,20,000.00	4	$       -81,961.61
Cash Operating Cost	$                   -1,20,000.00	5	$       -74,510.56
Cash Operating Cost	$                   -1,20,000.00	6	$       -67,736.87
Cash Operating Cost	$                   -1,20,000.00	7	$       -61,578.97
Cash Operating Cost	$                   -1,20,000.00	8	$       -55,980.89
Cash Operating Cost	$                   -1,20,000.00	9	$       -50,891.71
Cash Operating Cost	$                   -1,20,000.00	10	$       -46,265.19
Salvage Value	$                        30,000.00	10	$         11,566.30
NPV			$ -10,55,781.75

Purchase New System		Discounted Rate	10.00%
Particulars	Amount	Year
Purchase cost	$                   -4,00,000.00	0	$    -4,00,000.00
Salvage Value pf Present system	$                        90,000.00	0	$         90,000.00
Cash Operating Cost	$                       -90,000.00	1	$       -81,818.18
Cash Operating Cost	$                       -90,000.00	2	$       -74,380.17
Cash Operating Cost	$                       -90,000.00	3	$       -67,618.33
Cash Operating Cost	$                       -90,000.00	4	$       -61,471.21
Cash Operating Cost	$                       -90,000.00	5	$       -55,882.92
Cash Operating Cost	$                       -90,000.00	6	$       -50,802.65
Cash Operating Cost	$                       -90,000.00	7	$       -46,184.23
Cash Operating Cost	$                       -90,000.00	8	$       -41,985.66
Cash Operating Cost	$                       -90,000.00	9	$       -38,168.79
Cash Operating Cost	$                       -90,000.00	10	$       -34,698.90
Salvage Value of New system	$                        80,000.00	10	$         30,843.46
NPV			$    -8,32,167.58

Note:-

1. We have taken the Book Value of the Present system as net of its purchase price and the accumulated depreciation and the present Value will be same in the Year 0.

2. Assumed the Annual cash costs will be required from the First year to 10th Year.

3. We have considered the Salvage of Old system as Cash Inflow for the New System.

4. Formula used for Calculation of NPV = Cash Inflow/Outflow / (1+10%) ^ Period

Question 2.

Profitability Index = Present Value of Benefits / Present Value of Cost

Here we are only dealing Cash outflows regardless of the salvage Value therefore if the profitability Index is higher in terms that would not be beneficial for the company

Present System

Present Value of Cost = $ 10,67,348.05

Present Value of Benefits = $ 11,566.30

Profitability Index = $ 11,566.30 / 10,67,348.05 = 1.08%

New System

Present Value of Cost = $ 9,53,011.04

Present Value of Benefits = $ 1,20,843.46

Profitability Index = $ 1,20,843.46 / $ 9,53,011.04 = 12.68%

Question 3.

I would recommend the Investment in the New system.

Reasons:-

As per the Calculations I have done earlier, the NPV of the Cash Outflow is very less in the New system and Required Working capital also forms part of this project which will later be used for some other project.

There would be a direct saving of $ 2,23,614.18 if we go for the new project and Profitability Index is also far more than that of Existing system.

Therefore, this will be very in the interest of the company to procure the new system and prevent the company from incurring more cost on the existing system.

Thanks and Regards