(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 equipment is rebuilt, 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 equipment is rebuilt, the present value of the cash flows that occur now is:

Quizplus · Accepted Answer

The present value of cash flows for the rebuild option is calculated using the total cost approach to net present value analysis. The formula for this approach is:

Present value of cash flows = initial investment + present value of annual cost savings

For the rebuild option, the initial investment is $52,000 and the cost savings per year is $15,000. Using a discount rate of 12%, the present value of the cost savings over five years is:

PV = $15,000 x [(1 - (1 / 1.12^5)) / 0.12] = $47,499.12

Therefore, the present value of cash flows for the rebuild option is:

PV = $52,000 + $47,499.12 = $99,499.12

For the replace option, the initial investment is $120,000 and the salvage value after five years is $20,000. Using a discount rate of 12%, the present value of these cash flows is:

PV = -$120,000 + ($20,000 / 1.12^5) = -$55,506.69

Since the present value of cash flows for the replace option is negative, the best choice is to rebuild the equipment. The present value of cash flows for the rebuild option is $99,499.12, which is greater than the initial investment of $52,000. Therefore, Carlson Manufacturing should choose the rebuild option.

(Ignore Income Taxes in This Problem