(Ignore income taxes in this problem. )Allen College has a telephone system that is in poor condition.The system can be either overhauled or replaced with a new system.The following data have been gathered concerning these two alternatives: Allen College uses a 12% discount rate and the total cost approach to net present value analysis.Both alternatives are expected to have a useful life of eight years. The net present value of the alternative of overhauling the present system is closest to:

Question

(Ignore income taxes in this problem. )Allen College has a telephone system that is in poor condition.The system can be either overhauled or replaced with a new system.The following data have been gathered concerning these two alternatives:  Allen College uses a 12% discount rate and the total cost approach to net present value analysis.Both alternatives are expected to have a useful life of eight years. The net present value of the alternative of overhauling the present system is closest to:

Quizplus · Accepted Answer

We can calculate the Net Present Value (NPV) for both alternatives using the total cost approach.

For overhauling the present system: 
Initial investment = $800,000 
Annual maintenance cost = $130,000 
Salvage value at the end of 8 years = $0

The total present value of costs is: 
PV = $800,000 + ($130,000 / 0.12) * (1 - 1/1.12^8) = $1,708,650

For replacing the present system with a new one: 
Initial investment = $1,500,000 
Annual maintenance cost = $70,000 
Salvage value at the end of 8 years = $50,000

The total present value of costs is: 
PV = $1,500,000 + ($70,000 / 0.12) * (1 - 1/1.12^8) - ($50,000 / 1.12^8) = $1,932,882

Therefore, the NPV for overhauling the present system is: 
NPV = -$800,000 + $1,708,650 = $908,650

The NPV for replacing the present system with a new one is: 
NPV = -$1,500,000 + $1,932,882 = $432,882

Since overhauling the present system has a higher NPV, it is the better choice. Therefore, the answer is C.

(Ignore Income Taxes in This Problem