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 10% rate of return on its investments.

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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . \(112,000

Cost of overhaul . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Annual expected revenues generated . . . . . . . . . . . . . . . . . . 95,000

Annual cash operating costs after overhaul . . . . . . . . . . . . . . 42,000

Salvage value of old machine in 5 years . . . . . . . . . . . . . . . . 15,000

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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . \)300,000

Salvage value of old machine now . . . . . . . . . . . . . . . . . . 29,000

Annual expected revenues generated . . . . . . . . . . . . . . . 100,000

Annual cash operating costs . . . . . . . . . . . . . . . . . . . . . . . 32,000

Salvage value of new machine in 5 years . . . . . . . . . . . . 20,000

Required 1. Determine the net present value of alternative 1.

2. Determine the net present value of alternative 2.

3. Which alternative do you recommend that management select? Explain.

Short answer

The net present value of alternative 1 is $210,222 and alternative 2 is -$813 and alternative 1 is better.

Step-by-step solution

Step-by-Step SolutionStep 1: Computation of net present value of alternative 1

Initial cash investment (net) = $150,000
Charts values are based on:
I = 10%
Year	Subsequent cash inflow (outflow)	X	Table Factor	=	Present Value
1	$53,000	X	0.9090	=	$48,177
2	53,000	X	0.8264	=	43,799
3	53,000	X	0.7513	=	39,819
4	53,000	X	0.6830	=	36,199
5	53,000	X	0.6210	=	42,228
					$210,222

Computation of net present value of alternative 2

Initial cash investment (net) = $300,000
Charts values are based on:
I = 10%
Year	Subsequent cash inflow (outflow)	X	Table Factor	=	Present Value
1	$68,000	X	0.9090	=	$61,812
2	68,000	X	0.8264	=	56,195
3	68,000	X	0.7513	=	51,088
4	68,000	X	0.6830	=	46,444
5	68,000	X	0.6210	=	54,648
Now					29,000
					$299,187

$$\begin{gathered} \mathbf{Net}\mathbf{}\mathbf{Present}\mathbf{}\mathbf{Value}\mathbf{=}\mathbf{Present}\mathbf{}\mathbf{Value}\mathbf{}\mathbf{of}\mathbf{}\mathbf{cash}\mathbf{}\mathbf{in}\mathbf{}\mathbf{flows}\mathbf{-}\mathbf{Present}\mathbf{}\mathbf{Value}\mathbf{}\mathbf{of}\mathbf{}\mathbf{cash}\mathbf{}\mathbf{out}\mathbf{}\mathbf{flows} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{299}\mathbf{,}\mathbf{187}\mathbf{-}\mathbf{300}\mathbf{,}\mathbf{000} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{-}\mathbf{\$}\mathbf{813} \end{gathered}$$

Alternative selected by management

The management should select the alternative 1. This is because the present value of alternative 1 is better than alternative 2.