Question

Hook Industries is considering the replacement of one of its old metal stamping machines. Three alternative replacement machines are under consideration. The relevant cash flows associated with each are shown in the following​ table:

Initial investment   $84,600   $59,700   $129,900
Year          
1   $17,900   $12,500   $50,000
2   $17,900   $14,500   $30,100
3   $17,900   $15,500   $20,500
4   $17,900   $18,200   $20,500
5   $17,900   $19,800   $19,900
6   $17,900   $24,800   $29,600
7   $17,900   $0   $39,500
8   $17,900   $0   $49,900

a.  Calculate the net present value ​(NPV​) of EACH press.

b.  Using​ NPV, evaluate the acceptability of EACH press.

c.  Rank the presses from best to worst using NPV.

d.  Calculate the profitability index​ (PI) for EACH press.

e.  Rank the presses from best to worst using PI.

The​ firm's cost of capital is 12​%.

Answer 1

a.Replacement machine 1

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$84,600. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter the cost of capital of 12%
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 12% cost of capital is $4,320.75.

Replacement machine 2

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$59,700. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter the cost of capital of 12%
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 12% cost of capital is $9,418.55

Replacement machine 3

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$129,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter the cost of capital of 12%
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 12% cost of capital is $30,667.65.

b.All three of the replacement machines can be accepted since they generate a positive net present value.

c.Ranking of the replacement machines using NPV:

1.Replacement machine 3

2. Replacement machine 2

3. Replacement machine 1

d.Profitability index It is calculated using the below formula:

Profitability Index= NPV + Initial investment/ Initial investment

Replacement machine 1

Profitability Index= $4,320.75 + $84,600/ $84,600

                                   = $88,920.75/ $84,600

                                   = 1.0511.

Replacement machine 2

Profitability Index= $9,418.55 + $59,700/ $59,700

                                   = $69,118.55/ $59,700

                                   = 1.1578

Replacement machine 3

Profitability Index= $30,667.65 + $129,000

                                   = $159,667.65/ $129,000

                                   = 1.2377

e.Ranking of the replacement machines using profitability index:

1. Replacement machine 2

2. Replacement machine 3

3. Replacement machine 1

In case of any query, kindly comment on the solution.