Question

You are the director of a company and you are considering updating all of your computers to new models. Using the old computers you have net cash flows of $79,206 per year and it is estimated that with the new computers net cash flows would grow to $105,344 per year. Updating all of the computers would initially cost $115,878. The estimated remaining life of the old computers is 1 year and the expected lifetime of the new computers is 3 years. The scrap value of the old computers is estimated to be $12,673 irrespective of whether they are scrapped today or in 1 year. The new computers have an estimated scrap value at the end of their life of $13,940.

Management is considering two different options:

• Option 1: Use the old computers for 1 more year and then replace them with the new computers that will then be replaced every 3 years in perpetuity.
• Option 2: Replace the old computers with the new computers now and replace them every 3 years in perpetuity.

The company's required rate of return is 11.0% pa. Assume that the cost of the computers, the cash flows that they generate and their scrap value remain constant over time.

a)What is the net present value of option 1? Give your answer in dollars to the nearest dollar.

NPV = $

b)What is the net present value of option 2? Give your answer in dollars to the nearest dollar.

NPV = $

c)Which option will you undertake?

	Option 1:	Use the old computers for 1 more year and then replace them with the new computers that will then be replaced every 3 years in perpetuity.
	Option 2:	Replace the old computers with the new computers now and replace them every 3 years in perpetuity.

Answer 1

Option 2: Replace the old computers with the new computers now and replace them every 3 years in perpetuity.
Statement showing PV of cash Inflow of New computerswhen it replaces Old computers Now
cash Inflow of new machine per year	$ 1,05,344.00
Cumulative Present value of 3 years @11%	2.445
PV of Cash Inflows for 3 years	$ 2,57,566.00
($105344x2.445)
Less : Cash Out Flow
Purchase cost of new Computers	$ 1,15,878.00
Less : salavage value of Old Computers	-$     12,673.00
	$ 1,03,205.00
NPV of the cash Inflows For 3 years	$ 1,54,361.00
Equivalent Annual NPV of Cash Inflow	$      63,133.33
Option 1 : Use the old computers for 1 more year and then replace them with the new computers that will then be replaced every 3 years in perpetuity.
Statement showing PV of cash Inflow of Old computers
cash Inflow of Old Computers per year	$      79,206.00
Present value of 1 years @11%	0.9009
PV of Cash Inflows for 1 year	$      71,356.61
Statement showing PV of cash Inflow of New computerswhen it replaces Old computers
cash Inflow of new machine per year	$ 1,05,344.00
Cumulative Present value of 3 years @11%	2.445
PV of Cash Inflows for 3 years	$ 2,57,566.00
($105344x2.445)
Less : Cash Out Flow
Purchase cost of new Computers	$ 1,15,878.00
Less : salavage value of Old Computers	-$     12,673.00
	$ 1,03,205.00
NPV of the cash Inflows For 3 years	$ 1,54,361.00
Equivalent Annual NPV of Cash Inflow	$      63,133.33
The NPV of the 1st year with the old computers is more than the Equivalent annaual NPV of the New Computers Since it was suggested to use old computers to 1 More year and then repalce them with the new computers