Initial cost $90,000 $170,000
Net annual cash flows $20,000 $32,000
Cost to rebuild (end of year 5) $26,500 $0
Salvage value $0 $27,500
Estimated useful life 8 years 8 years
A's cash flows...
Cashflow "CF" 0 = (90,000)
Depreciation: 90,000 / 8 = 11,250 per year + net annual 20,000 = 31,250
CF#5: 21,250 - 26,500rebuild cost = 4,750
CF#6-8: 31,250 (technically you would probably capitalize the rebuild cost, because its benefits last three years, not just for the current period, and then amortize that cost thru depreciation. Either way, there is an actual cash cost to rebuild at the end of year 5. The additional depreciation to add back to CF for the last three years would be: 26,500 / 3 = $8,333.33)
NPV: (90k) + 31,250/1.09 + 31,250/1.09^2 + 31,250/1.09^3 + 31,250/1.09^4 + 4,750/1.09^5 +
31,250/1.09^6 + 31,250/1.09^7 + 31,250/1.09^8
NPV = $65,739.92
IRR = 27.27481%
B:
CF0 = (170,000)
CF#1 - 7: Depreciation (170,000 cost - 27,500 salvage) / 8 = 17,812.50 + 32,000 annual cash flow = 49,812.50
CF#8: 49,812.50 + 27,500 salvage (assumed sold for salvage at end of year 8) = $77,312.50
NPV: (170,000) + 49,812.50/1.09 + 49,812.50/1.09^2 + ...fill in missing discounted CFs..+ 77,312.50/1.09^9
NPV = $119,504.50
IRR = 25.09%
Stratton Testing is considering investing in a new testing device. It has two options: Option A would have an initial lower cost but would require a significant expenditure for rebuilding after 5 years. Option B would require no rebuilding expenditure, but its maintenance costs would be higher. Since the option B machine is of initial higher quality, it is expected to have a salvage value at the end of its useful life. The following estimates were provided. The company’s cost of capital is 9%.
Option A
Option B
Initial cost $90,000 $170,000
Net annual cash flows $20,000 $32,000
Cost to rebuild (end of year 5) $26,500 $0
Salvage value $0 $27,500
Estimated useful life 8 years 8 years
(a)
Compute the (1) net present value, and (2) internal rate of return for each option. (Hint: To solve for internal rate of return, experiment with alternative discount rates to arrive at a net present value of zero.) (Round PV factor to 5 decimal places, e.g. 1.25356 and final answer to 0 decimal places, e.g.1,255.)
