Question

X Company must decide whether to continue using its current equipment or replace it with new, more efficient equipment. The following information is available for the current and new equipment:

Current equipment

Current sales value $5,000

Final sales value 5,000

Operating costs 60,500

New equipment

Purchase cost $45,000

Final sales value 5,000

Operating costs 52,000

Maintenance work will be necessary on the new equipment in Year 4, costing $2,500. The current equipment will last for five more years; the life of the new equipment is also five years. Assuming a discount rate of 7%, what is the net present value of replacing the current equipment

Answer 1

Firstly we need to calculate net increase or decrease in cash flows if the current equipment is replaced with new equipment which is calculated as follows:-

Net Cost of new equipment = Cost of new equipment - Sale Proceeds of Current Equipment

= $45,000 - $5,000 = $40,000

Annual Savings in Operating Costs

= Operating cost with current equipment - operating cost with new equipment

= $60,500 - $52,000 = $8,500

Extra Maintenance cost in year 4 = $2,500

Step 2:- Now all the cash flows will be discounted to their present value at the rate of 7%.

Present Value of annual Savings = Annual Savings*PVAF(7%,5 yrs)

= $8,500*4.1002 = $34,852

Present Value of Extra maintenance cost = $2,500*PVF(7%, 4 yrs)

= $2,500*0.762895 = $1,907

Net Present Value of replacing the Current Equipment

= PV of Annual Savings-PV of extra cost-Net cost of Equipment

= $34,852-$1,907-$40,000 = -$7,055

Therefore the net present value of replacing the current equipment is negative [i.e. (-)$7,055].