Question

Upper A minus 1A−1 Chips is a manufacturer of prototype chips based in​ Dublin, Ireland. Next​ year, in 2018​, Upper A minus 1A−1 Chips expects to deliver 525

prototype chips at an average price of $105,000. Upper A minus 1A−1 ​Chips' marketing vice president forecasts growth of 65

prototype chips per year through 2024. That​ is, demand will be 525 in 2018​, 590 in 2019​, 655 in 2020​, and so on.

The plant cannot produce more than 495 prototype chips annually. To meet future​ demand, Upper A minus 1A−1 Chips must either modernize the plant or replace it. The old equipment is fully depreciated and can be sold for $3,800,000 if the plant is replaced. If the plant is​ modernized, the costs to modernize it are to be capitalized and depreciated over the useful life of the updated plant. The old equipment is retained as part of the modernize alternative. The following data on the two options are​ available:

Modernize	Replace
Initial investment in 2018	$36,100,000	$61,700,000
Terminal disposal value in 2024	$6,600,000	$17,300,000
Useful life	7 years	7 years
Total annual cash operating cost per prototype chip	$86,500	$78,000

Upper A minus 1A−1 Chips uses​ straight-line depreciation, assuming zero terminal disposal value. For​ simplicity, we assume no change in prices or costs in future years. The investment will be made at the beginning of 2018​, and all transactions thereafter occur on the last day of the year. Upper A minus 1A−1 ​Chips' required rate of return is 10​%.

There is no difference between the modernize and replace alternatives in terms of required working capital. Upper A minus 1A−1 Chips has a special waiver on income taxes until 2024.

Answer 1

Sol. Option-1 Modernize

Step-1 - Initial Investment = $36,100,000 Outflow

Step-2 - Annual Cash flow

Year	No. of Chips(a)	Operating cost per prototype Chip (b)	Total Cost (a * b)	PVF @ 10%	Net Present Value
1	525	86500	45412500	0.909	41279962
2	590	86500	51035000	0.826	42154910
3	655	86500	56657500	0.751	42549783
4	720	86500	62280000	0.683	42537240
5	785	86500	67902500	0.621	42167452
6	850	86500	73525000	0.564	41468100
7	915	86500	79147500	0.513	40602668
				Outflow	292760115

Step-3 - Terminal Cashflow = 6600,000 * PVF(10%, 7 years) = 6600,000 * 0.513 = $ 3,385,800 Inflow

Step-4 - NPV = 3,385,800 - 292,760,115 - 36,100,000

= $325,474,315 outfllow

Option-2 Replace

Step-1 - Initial Investment = $61,700,000 New equipment - 3,800,000 sale of old = 57,900,000 Outflow

Step-2 - Annual Cash flow

Year	No. of Chips(a)	Operating cost per prototype Chip (b)	Total Cost (a * b)	PVF @ 10%	Net Present Value
1	525	78000	40950000	0.909	37223550
2	590	78000	46020000	0.826	38012520
3	655	78000	51090000	0.751	38368590
4	720	78000	56160000	0.683	38357280
5	785	78000	61230000	0.621	38023830
6	850	78000	66300000	0.564	37393200
7	915	78000	71370000	0.513	36612810
				Outflow	263991780

Step-3 - Terminal Cashflow = 17,300,000 * PVF(10%, 7 years) = 17,300,000 * 0.513 = $ 8,874,900 Inflow

Step-4 - NPV = 8,874,900 - 263,991,780 - 57,900,000

= $313,016,880 outflow

Decision - Replacement option is cheaper in cost