(Ignore income taxes in this problem. )Carlson Manufacturing has some equipment that needs to be rebuilt or replaced.The following information has been gathered relative to this decision: Carlson uses the total cost approach to net present value analysis and a discount rate of 12%.Regardless of which option is chosen, rebuild or replace, at the end of five years Carlson Manufacturing will have no future use for the equipment. If the new equipment is purchased, the present value of the cash flows that occur now is:

Question

(Ignore income taxes in this problem. )Carlson Manufacturing has some equipment that needs to be rebuilt or replaced.The following information has been gathered relative to this decision:  Carlson uses the total cost approach to net present value analysis and a discount rate of 12%.Regardless of which option is chosen, rebuild or replace, at the end of five years Carlson Manufacturing will have no future use for the equipment. If the new equipment is purchased, the present value of the cash flows that occur now is:

Quizplus · Accepted Answer

Using the total cost approach to net present value analysis, we need to calculate the present value of both options.
For the rebuild option:
Initial cost = $20,000
Annual maintenance cost = $6,000
Salvage value at the end of 5 years = $0
Discount rate = 12%
Using the formula, Present value = [Annual maintenance cost / discount rate] x [1 - (1 / (1+discount rate)^n)] + [Salvage value / (1+discount rate)^n]
Present value = [6000/0.12] x [1 - (1 / (1.12)^5)] + [0/(1.12)^5]
Present value = $23,039.50

For the replace option:
Initial cost = $75,000
Annual operating cost = $4,500
Salvage value at the end of 5 years = $15,000
Discount rate = 12%
Using the formula, Present value = - Initial cost + [Annual operating cost / discount rate] x [1 - (1 / (1+discount rate)^n)] + [Salvage value / (1+discount rate)^n]
Present value = -75000 + [4500/0.12] x [1 - (1 / (1.12)^5)] + [15000/(1.12)^5]
Present value = $62,039.50

Therefore, the present value of the cash flows that occur now for the purchase of new equipment is ($62,039.50). This is higher than the present value of cash flows for the rebuild option, which is ($23,039.50). Hence, the best choice is to replace the equipment.

(Ignore Income Taxes in This Problem