Question

eBook Overton Clothes Inc. is considering the replacement of its old, fully depreciated knitting machine. Two new models are available: (a) Machine 171-3, which has a cost of $177,000, a 3-year expected life, and after-tax cash flows (labor savings and depreciation) of $88,000 per year; and (b) Machine 356-6, which has a cost of $344,000, a 6-year life, and after-tax cash flows of $99,800 per year. Assume that both projects can be repeated. Knitting machine prices are not expected to rise because inflation will be offset by cheaper components (microprocessors) used in the machines. Assume that Overton’s WACC is 11%. Using the replacement chain and EAA approaches, which model should be selected? Why? Both new machines have positive NPVs; hence the old machine should be replaced. Further, since its NPV is greater with the replacement chain approach and its EAA is higher than Model -Select-171-3356-6 , choose Model -Select- (171-3, 356-6).

Answer 1

Machine 356-6
Initial cost	344,000.00	$
Life	6	Years
cash inflows	99,800.00	$
Rate	11.00	%

Year	PV factor 11% [1/(1+r)^n]
1	0.901
2	0.812
3	0.731
4	0.659
5	0.593
6	0.535
Total	4.231

NPV = Discounted inflow - Initial investment
Discounted inflow = Annual inflow * total PV factor
=	99800 * 4.231
=	422,253.80
NPV=	422253.80 - 344000
=	78,253.80
EAA=	NPV / Total PV factor
=	78253.80 / 4.231
=	18,495.34

Machine 171-3
Initial cost	177,000.00	$
Life	3	Years
cash inflows	88,000.00	$
Rate	11	%

Year	PV factor 11% [1/(1+r)^n]
1	0.901
2	0.812
3	0.731
Total	2.444

NPV = Discounted inflow - Initial investment
Discounted inflow = Annual inflow * total PV factor
=	88000 * 2.444
=	215,072.00
NPV=	215072 - 177000
=	38,072.00
EAA=	NPV / Total PV factor
=	38072 / 2.444
=	15,577.74

Project	EAA	NPV
Machine 356-6	18,495.34	78,253.80
Machine 171-3	15,577.74	38,072.00
Since Machine 356-6 has highest EAA as well as NPV, Machine 356-6 should be undertaken