Question

Interstate Manufacturing is considering either replacing one of its old machines with a new machine or having the old machine overhauled, Information about the two alternatives follows. Management requires a 8% rate of return on its investments. Use the (PV of $1. FV of $1. PVA of $1, and FVA of $1) (Use appropriate factor(s) from the tables provided.) Alternative 1: Keep the old machine and have it overhauled. If the old machine is overhauled, it will be kept for another five years and then sold for its salvage value. Cost of old machine Cost of overhaul Annual expected revenues generated Annual cash operating costs after overhaul Salvage value of old machine in 5 years $109,000 144,000 94.000 42,000 21,000 Alternative 2: Sell the old machine and buy a new one. The new machine is more efficient and will yield substantial operating cost savings with more product being produced and sold. Cost of new machine Salvage value of old machine now Annual expected revenues generated Annual cash operating costs Salvage value of new machine in 5 years $298.000 47.000 112.000 23,000 11,000

Answer 1

1. Determine the net present value of Alternative 1:- old machine

Initial cash investment(net) = overhauling cost = 144,000

cash inflows per year = Revenue - cash operating costs

therefore for 4 years = 94000 - 42000 = 52000

Cash inflow for 5th year = Revenue + salvage value of machine - cash operating costs

so for 5th year cash flow is 94000 + 21000 - 42000 = 73000

Year	Subsequent cash inflow(outflow)	*	Table factor	=	Present value
1	52000	*	0.9259	=	48,146.80
2	52000	*	0.8573	=	44,579.60
3	52000	*	0.7938	=	41,277.60
4	52000	*	0.735	=	38,220.00
5	73000	*	0.6806	=	49,683.80
Now	Total Present value				221,907.80

Total present value of cash flows of 5 years = 221,907.80

Less : Initial cash investment (net)    = 144,000.00

Net present value = $ 77,907.80

2. Determine the net present value of Alternative 2:- New machine

Initial cash investment(net) = cost of new machine - salvage of old machine = 298,000 - 47,000 = 251,000

cash inflows per year = Revenue - cash operating costs

therefore for 4 years = 112000 - 23000 = 89000

Cash inflow for 5th year = Revenue + salvage value of new machine - cash operating costs

so for 5th year cash flow is 112000 + 23000 - 11000 = 100000

Year	Subsequent cash inflow(outflow)	*	Table factor	=	Present value
1	89000	*	0.9259	=	82,405.10
2	89000	*	0.8573	=	76,299.70
3	89000	*	0.7938	=	70,648.20
4	89000	*	0.735	=	65,415.00
5	100000	*	0.6806	=	68,060.00
Now	Total Present value				362,828.00

Total present value of cash inflows for 5 years = 362,828.00

Less : Initial cash investment (new) = 251,000.00

Net present value = $ 111,828.00

3.Which Alternative should management select ?

As per the above calculations, we can see that the alternative 2 has higher net present value ($ 111828) than the net present value of alternative 1 ($ 77,907) therefore the management should select Alternative 2