Question

The RW, Inc. is proposing an investment in energy-saving equipment. The new equipment requires a $9 million investment. The attraction of the new equipment is that it would create an operating cost savings by cutting manufacturing costs. Currently, these costs are $8 per unit. However, as the following table shows, there is some uncertainty both about future sales and about the performance of the new machinery: Pessimistic Expected Optimistic Sales (Millions of Cost with new Economic life of new 0.4 0.5 4 10 0.7 3 13 Units) machinery (S/Unit) 7 machine (Years) Management feels that the new equipment would be so customized to RW's needs that there would be no used equipment market for it, and consequently, it would have a zero salvage value. The cost of capital is 12%. Assume working capital would be unchanged and RW pays no taxes. Under each scenario, do the operating cost savings justify the investment in the new equipment? Hint: Calculate the annual operating cost savings net of the EAC of the initial investment for each scenario a. Pessimistic: No: Expected: No: Optimistic: No b. Pessimistic: No; Expected: No; Optimistic: Yes c. Pessimistic: No; Expected: Yes; Optimistic: Yes d. Pessimistic: Yes; Expected: Yes: Optimistic: Yes

Answer 1

	Pessimistic	Expected	Optimistic
Sales in units	400000	500000	700000
Current cost per unit ($)	6	4	3
Cost per unit with new machinery ($)	8	8	8
Costs savings per unit if, new machinery is istalled	2	4	5
Total cost savings per year	800000	2000000	3500000
EAC of new machine:
=-9000000*0.12*1.12^7/(1.12^7-1) =	-1972060
=-9000000*0.12*1.12^10/(1.12^10-1) =		-1592857
=-9000000*0.12*1.12^13/(1.12^13-1) =			-1401095
Equivalent Annual Present Worth	-1172060	407143	2098905
Amswer:
Option [c] =	No	Yes	Yes