Mar Vista Molding Company is considering investing in new therrnokillian equipme
ID: 2496770 • Letter: M
Question
Mar Vista Molding Company is considering investing in new therrnokillian equipment. It has two options: Option A would have an initial lower cost but would require a significant expenditure for rebuilding after 3 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 made of the cash flows: Option A Option B Initial cost $53,000 $58,000 Annual cash inflows $30,000 $30,000 Annual cash outflows $15,000 $18,000 Cost to rebuild (end of year 3) $12,000 $ -0- Salvage value S -0- 510,000 Estimated useful life 6 years 6 years The company"s cost of capital is 8%. Instructions (a) Compute the (1) net present value, (2) profitability index, and (3) internal rate of return for each option. (b) Which option should be accepted?
Explanation / Answer
Mar Vista Molding Actual result may vary with the given result to you due to difference in discounting factor digits used, Here 4 digit factor used for accuracy. Option A Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Initial Cost (53,000) Annual Cash inflow 30,000 30,000 30,000 30,000 30,000 30,000 Annual cash outflow (15,000) (15,000) (15,000) (15,000) (15,000) (15,000) Rebuild -12000 Net Inflow 15,000 15,000 3,000 15,000 15,000 15,000 Discount factor @8% 1 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 PV of net Cash Inflows 13,889 12,860 2,381 11,025 10,209 9,453 Total PV of net cash inflows 59,817 NPV 6,817 PI = 59,817/53000= 1.13 IRR Calculation Option A Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Initial Cost (53,000) Annual Cash inflow 30,000 30,000 30,000 30,000 30,000 30,000 Annual cash outflow (15,000) (15,000) (15,000) (15,000) (15,000) (15,000) Rebuild -12000 Net Inflow 15,000 15,000 3,000 15,000 15,000 15,000 Discount factor @12.1% 1 0.8921 0.7958 0.7099 0.6333 0.5649 0.5039 PV of net Cash Inflows 13,381 11,937 2,130 9,499 8,474 7,559 Total PV of net cash inflows 52,978 NPV (22) So at required return 12.1% the NPV is 0 So IRR =12.1% Option B Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Salvage value considered $10,000 as $ 510,000 is absurd value, calculation will change based on correct salvage value Initial Cost (58,000) Annual Cash inflow 30,000 30,000 30,000 30,000 30,000 30,000 Annual cash outflow (18,000) (18,000) (18,000) (18,000) (18,000) (18,000) Salvage 10,000 Net Inflow 12,000 12,000 12,000 12,000 12,000 22,000 Discount factor @8% 1 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 PV of net Cash Inflows 11,111 10,288 9,526 8,820 8,167 13,864 Total PV of net cash inflows 61,776 NPV 3,776 PI = 61,776/58,000 1.07 Option B Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Salvage value considered $10,000 as $ 510,000 is absurd value, calculation will change based on correct salvage value Initial Cost (58,000) Annual Cash inflow 30,000 30,000 30,000 30,000 30,000 30,000 Annual cash outflow (18,000) (18,000) (18,000) (18,000) (18,000) (18,000) Salvage 10,000 Net Inflow 12,000 12,000 12,000 12,000 12,000 22,000 Discount factor @9.95% 1 0.9095 0.8272 0.7523 0.6843 0.6223 0.5660 PV of net Cash Inflows 10,914 9,926 9,028 8,211 7,468 12,452 Total PV of net cash inflows 58,000 NPV (0) So at required return 9.95% NPV is 0 So IRR is 9.95% Based on higher NPV, PI and IRR , project A should be selected.