Question

Clean Chips is a manufacturer of prototype chips based in? Dublin, Ireland. Next? year, in 2015?, Clean Chips expects to deliver 622 prototype chips at an average price of $ 110000.
Clean ?Chips' marketing vice president forecasts growth of 85 prototype chips per year through 2021.
That? is, demand will be 622 in 2015?, 707 in 2016?, 792 in 2017?, and so on.
The plant cannot produce more than 597 prototype chips annually.
To meet future? demand, Clean Chips must either modernize the plant or replace it.
The old equipment is fully depreciated and can be sold for $ 4100000 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 2015	$37,100,000		$62,500,000
Terminal disposal value in 2021	$6,800,000		$15,500,000
Useful life	7 years		7 years
Total annual cash operating cost per prototype chip	$93,000		$85,000

CleanCleanChips 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 of2015?,and all transactions thereafter occur on the last day of the year.

CleanClean?Chips' required rate of return is6?%.There is no difference between the modernize and replace alternatives in terms of required working capital.

CleanCleanChips has a special waiver on income taxes until2021.

1.	Sketch the cash inflows and outflows of the modernize and replace alternatives over the2015-2021period.
2.	Calculate payback period for the modernize and replace alternatives.
3.	Calculate net present value of the modernize and replace alternatives.
4.	What factors shouldCleanCleanChips consider in choosing between the?alternatives?

Answer 1

(1) Cash Inflows & Outflows :-

Modernize
Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
Clean chips deliver (A)		622	707	792	877	962	1047	1132
Average price		110000	110000	110000	110000	110000	110000	110000
Operating cost per prototype		-93000	-93000	-93000	-93000	-93000	-93000	-93000
Cash inflow per prototype (B)		17000	17000	17000	17000	17000	17000	17000
Cash inflow from prototype (A*B)		10574000	12019000	13464000	14909000	16354000	17799000	19244000
Initial Investment	-37100000
Terminal Disposal Value								6800000
Total Cash Inflow/Outflow	-37100000	10574000	12019000	13464000	14909000	16354000	17799000	26044000

Replace
Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
Clean chips deliver (A)		622	707	792	877	962	1047	1132
Average price		110000	110000	110000	110000	110000	110000	110000
Operating cost per prototype		-85000	-85000	-85000	-85000	-85000	-85000	-85000
Cash inflow per prototype (B)		25000	25000	25000	25000	25000	25000	25000
Cash inflow from prototype(A*B)		15550000	17675000	19800000	21925000	24050000	26175000	28300000
Initial Investment	-62500000
Sale value of old machinery	4100000
Terminal Disposal Value								15500000
Total Cash Inflow/Outflow	-58400000	15550000	17675000	19800000	21925000	24050000	26175000	43800000

(2) Payback Period:-

Modernise			Replace
	Cash Inflow	Cash Inflow (–) Cash Outflow		Cash Inflow	Cash Inflow (–) Cash Outflow
Year 0		-37100000	Year 0		-58400000
Year 1	10574000	-26526000	Year 1	15550000	-42850000
Year 2	12019000	-14507000	Year 2	17675000	-25175000
Year 3	13464000	-1043000	Year 3	19800000	-5375000
Year 4	14909000	13866000	Year 4	21925000	16550000
Year 5	16354000	30220000	Year 5	24050000	40600000
Year 6	17799000	48019000	Year 6	26175000	66775000
Year 7	26044000	74063000	Year 7	43800000	110575000

Payback period for Modernise = 3 year + 1043000/14909000 = 3.07 years

Payback period for Replace = 3 year + 5375000/21925000= 3.245 years

(3) NPV:-

Modernise
	Cash flows	PV Factor @ 6%	PV of cash flows
Year 0	-37100000	1	-37100000
Year 1	10574000	0.943396226	9975471.698
Year 2	12019000	0.88999644	10696867.21
Year 3	13464000	0.839619283	11304634.03
Year 4	14909000	0.792093663	11809324.43
Year 5	16354000	0.747258173	12220660.16
Year 6	17799000	0.70496054	12547592.66
Year 7	26044000	0.665057114	17320747.47
		NPV	48775297.65

Replace
	Cash flows	PV Factor @ 6%	PV of cash flows
Year 0	-58400000	1	-58400000
Year 1	15550000	0.943396226	14669811.32
Year 2	17675000	0.88999644	15730687.08
Year 3	19800000	0.839619283	16624461.8
Year 4	21925000	0.792093663	17366653.57
Year 5	24050000	0.747258173	17971559.06
Year 6	26175000	0.70496054	18452342.15
Year 7	43800000	0.665057114	29129501.58
		NPV	71545016.55

(4)

	Modernise	Replace
Payback Period	3.07 years	3.245 years
NPV	48775297.65	71545016.55

Modernise is better as per Payback period

Replace is better as per NPV method

If company wants to recover its Initial Investment earlier then Modernise is better

But in Replace alternative , Initial Investment is very high as compare to Modernise alternative.

Hence its Payback period is more.But in this alternative Cash inflows are also high.Thats why its NPV is more than Modernise.