Question

MRM Inc. has additional cash available for investment. One of the production machines needs to be replaced, and management is considering two options. Both options require a similar initial outlay and have a useful life of 8 years. Option #1 will generate $10,000 annually in positive after-tax cash flows and would have an after-tax residual value of $10,000. Option #2 will generate $11,000 annually in positive after-tax cash flows and would have an after-tax residual value of $1,000. Using a discount rate of 9%, which option is the most attractive?

a)option #1

b) option#2

Answer 1

(b) Option #2 is the answer.

For selecting the most attractive investment, we will caculate the present value of cash flows of both the projects. Since the initial investment in both the projects is same, so we will simply check, which option is giving the highest present value of cash flows.

Present value of cash flows for option #1 = Present value of annuity of $10000 for 8 years @ 9% rate + Present value of $10000 after 8 years at 9%discount rate

= $10000 * PVIFA (9%, 8 years) + $10000 * PVIF(9%, 8 years)

$10000 * 5.5348 + $10000 * 0.5019

= $55348 + $5019

= $60367

Present value of cash flows for option #2 = Present value of annuity of $11000 for 8 years @ 9% rate + Present value of $1000 after 8 years at 9%discount rate

= $11000 * PVIFA (9%, 8 years) + $1000 * PVIF(9%, 8 years)

= $11000 * 5.5348 + ($1000 * 0.5019)

= $60882.8 + $501.9

= $61384.7

Since option #2 has higher present value of cash flows, so it is most attractive.