Question

Max Chips is a manufacturer of prototype chips based in​ Dublin, Ireland. Next​ year, in 2018​, Max Chips expects to deliver 615 prototype chips at an average price of $65,000. Max Chips' marketing vice president forecasts growth of 55 prototype chips per year through 2024. That​ is, demand will be 615 in 2018​, 670 in 2019​, 725 in 2020​, and so on.

The plant cannot produce more than 590 prototype chips annually. To meet future​demand, Max Chips must either modernize the plant or replace it. The old equipment is fully depreciated and can be sold for $3,700,000 if the plant is replaced. If the plant is​ modernized, the costs to modernize it are to be capitalized and depreciated over the useful life of the updated plant. The old equipment is retained as part of the modernize alternative. The following data on the two options are​ available:

	Modernize		Replace
Initial investment in 2018	$37,100,000		$66,500,000
Terminal disposal value in 2024	$6,800,000		$14,500,000
Useful life	7 years		7 years
Total annual cash operating cost per prototype chip	$49,000		$40,000

Max Chips uses​ straight-line depreciation, assuming zero terminal disposal value. For​ simplicity, we assume no change in prices or costs in future years. The investment will be made at the beginning of 2018​, and all transactions thereafter occur on the last day of the year. Max Chips' required rate of return is 16​%. There is no difference between the modernize and replace alternatives in terms of required working capital. Max Chips has a special waiver on income taxes until 2024.

Requirement 1. Calculate the cash inflows and outflows of the modernize and replace alternatives over the 2018

​- 2024 period. ​First, determine the cash inflows and outflows of the modernize alternative over the 2018 to 2024

period.

Requirement 2. Calculate payback period for the modernize and replace alternatives.

Requirement 3. Calculate net present value of the modernize and replace alternatives.

	Units	Net cash	Initial	Proceeds from
Year	sold	contributions	investments	sale of equipment
Jan 1, 2018
Dec 31, 2018
Dec 31, 2019
Dec 31, 2020
Dec 31, 2021
Dec 31, 2022
Dec 31, 2023
Dec 31, 2024

Answer 1

• NPV is excess of Present Value of Cash Inflows over Net Outflows at Present Value.
• PayBack Period is duration in which business is able to recover its initial investment without considering Present Value, ignoring discount factors.
• Depreciation is not considered for cash outflows as Enterprise is in Tax Holiday Period, hence depreciation will not lead to any savings of Tax Expense.

Period	Year	Output	Present Value Factor @16%
1	2018	615	0.862
2	2019	670	0.743
3	2020	725	0.641
4	2021	780	0.552
5	2022	835	0.476
6	2023	890	0.410
7	2024	945	0.354

Particulars	Modernize	Replace
Initial investment in 2018	37,100,000	66,500,000
Terminal disposal value in 2024	6,800,000	14,500,000
Useful life (In Years)	7	7
Total annual cash operating cost per Unit	49,000	40,000
Annual Depreciation	971,429	2,071,429
(Initial investment/ Useful Life)
Disposal Value for Depreciation	Nil	Nil

Sales Value in Case of Replacement

3,700,000

Particulars Per Unit	Modernize	Replace
Average Sales Price	65,000	65,000
Cash Operating cost	49,000	40,000
Cash Operating Inflows	16,000	25,000

Calculation of Cash Inflows in Modernize Approach
Year	2018	2019	2020	2021	2022	2023	2024
Output	615	670	725	780	835	890	945
Cash Operating Inflows	16,000	16,000	16,000	16,000	16,000	16,000	16,000
Total Cash Operating Inflows	9,840,000	10,720,000	11,600,000	12,480,000	13,360,000	14,240,000	15,120,000
Present Value Factor @16%	0.862	0.743	0.641	0.552	0.476	0.410	0.354
Present Value of Operating Cash Flows	8,482,759	7,966,706	7,431,629	6,892,593	6,360,870	5,844,698	5,349,902
Cumulative Present Value of Operating Cash Flows	8,482,759	16,449,465	23,881,094	30,773,687	37,134,557	42,979,254	48,329,157
Cumulative Cash Operating Inflows	9,840,000	20,560,000	32,160,000	44,640,000	58,000,000	72,240,000	87,360,000

Calculation of Cash Inflows in Replacement Approach
Year	2018	2019	2020	2021	2022	2023	2024
Output	615	670	725	780	835	890	945
Cash Operating Inflows	25,000	25,000	25,000	25,000	25,000	25,000	25,000
Total Cash Operating Inflows	15,375,000	16,750,000	18,125,000	19,500,000	20,875,000	22,250,000	23,625,000
Present Value Factor @16%	0.862	0.743	0.641	0.552	0.476	0.410	0.354
Present Value of Operating Cash Flows	13,254,310	12,447,979	11,611,920	10,769,676	9,938,859	9,132,340	8,359,223
Cumulative Present Value of Operating Cash Flows	13,254,310	25,702,289	37,314,209	48,083,886	58,022,745	67,155,085	75,514,308
Cumulative Cash Operating Inflows	15,375,000	32,125,000	50,250,000	69,750,000	90,625,000	112,875,000	136,500,000

Calculation of Terminal Values at End of 2024
Particulars	Modernize	Replace
Terminal disposal value in 2024	6,800,000	14,500,000
Discount Factor @16%, YEAR 2024	0.354	0.354
Present Value of Terminal Cash INFlows	2,406,041	5,130,528
Calculation of NPV of Projects
Particulars	Modernize	Replace
Operating Cash Flows at PV	48,329,157	75,514,308
Present Value of Terminal Cash INFlows	2,406,041	5,130,528
Sales Value in Case of Replacement	-	3,700,000
Initial investment in 2018	- 37,100,000	- 66,500,000
NPV of Proposals	13,635,198	17,844,836
Calculation of Payback Period Without Considering Discounting
Particulars	Modernize	Replace
Initial investment in 2018	37,100,000	66,500,000
Cumulative Cash at End of Year 3	32,160,000	50,250,000
Variance in Investment (X)	4,940,000	16,250,000
Differnce Between Year 3 & 4 (Y)	12,480,000	19,500,000
Using Interpolation (X/Y)	0.40	0.83
Payback Period	3.396	3.833