Question

Software Inc. is considering a replacement of its air conditioner system. The company has two systems to choose:
-   Matsu-Cool models cost $40,000 to purchase, result in electricity bills of $15,000 per year, and last for 5 years.
-   Tuba-Air models cost $60,000 to purchase, result in electricity bills of $10,000 per year, and last for 7 years.
Both systems are fully depreciated straight line. Assume that the company will replace the air conditioner when it wears out. The tax rate is 40%. The discount rate is 15%.
Which model should the company choose? Why?
(Excel format)

Answer 1

i)NPV of Matsu-Cool models is calculated as follows,

NPV = Present Value of Cash Inflows -Present Value of Cash Outflows

Year	Cash Flows	PV factor @ 15%	PV of Cash Flows
0	(40,000)	1.00	(40,000.00)
1	(5,800)	0.87	(5,043.48)
2	(5,800)	0.76	(4,385.63)
3	(5,800)	0.66	(3,813.59)
4	(5,800)	0.57	(3,316.17)
5	(5,800)	0.50	(2,883.63)
NPV @ 15%			(59,442.50)

Cash flows are calculated as follows,

Particulars	Amount
Depreciation	8,000.00
A. Tax Savings on depreciation	3,200.00
Electricity charge	15,000.00
Tax on Electricity charge	6,000.00
B. After tax Electricity charge	9,000.00
Net cash flow (A-B)	(5,800.00)

ii)NPV of Tuba-Air models is calculated as follows,

NPV = Present Value of Cash Inflows -Present Value of Cash Outflows

Year	Cash Flows	PV factor @ 15%	PV of Cash Flows
0	(60,000)	1.00	(60,000.00)
1	(2,571)	0.87	(2,236.02)
2	(2,571)	0.76	(1,944.37)
3	(2,571)	0.66	(1,690.76)
4	(2,571)	0.57	(1,470.22)
5	(2,571)	0.50	(1,278.45)
6	(2,571)	0.43	(1,111.70)
7	(2,571)	0.38	(966.70)
NPV @ 15%			(67,341.37)

Cash flows are calculated as follows,

Particulars	Amount
Depreciation	8,571.43
A. Tax Savings on depreciation	3,428.57
Electricity charge	10,000.00
Tax on Electricity charge	4,000.00
B. After tax Electricity charge	6,000.00
Net cashflow	(2,571.43)

iii)Which model should the company choose

The company should choose Matsu-Cool models.

A project is accepted when NPV is greater than zero and rejected when NPV is less than zero. In case of two projects with NPV which is less than zero i.e., Negative NPV, the project with least Negative NPV is choosen. Here Matsu-Cool models has least Negative NPV. So this model should be choosen.