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

A	The net present value of option 1
		EXISTING	WITH NEW FOR THREE YEAR
		FOR YEAR1	FOR YEAR2	FOR YEAR3	TOTAL
	INTIAL COST		115878		115878
	CASH FLOW	79206	105344	105344
	SCRAP VALU	12673
	TOTAL CASH FLOW	91879	105344	105344
	NPV FACTOR AT 11%	0.901	0.812	0.732
	PRESENT VALUE OF CASH FLOWS	82783	85539	77112	324042
	NET PRESENT VALUE
	(CASH OUTFLOW LESS INFLOW)				208164
B	The net present value of option 2
		NEW	WITH NEW FOR THREE YEAR
		FOR YEAR1	FOR YEAR2	FOR YEAR3	TOTAL
	INTIAL COST	115878			115878
	CASH FLOW	105344	105344	105344
	SCRAP VALU OLD COMPUTER	12673		13940
	TOTAL CASH FLOW	118017	105344	119284
	NPV FACTOR AT 11%	0.901	0.812	0.732
	PRESENT VALUE OF CASH FLOWS	106333	85539	87316	357797
	NET PRESENT VALUE
	(CASH OUTFLOW LESS INFLOW)				241919
	Option 2 will under take because it shows an
C	INCREMENTAL CASH FLOW				33755