Question

Over the River Bridge Company needs to replace its CNC Machining line. They have 3 different options for the replacement.

Option 1:

Replace the worn-out equipment with the same equipment. The quoted price of this equipment is $16,500,000 due in full upon delivery. This equipment uses $185,000 of electricity a year. It has a service life of 5 years. It has a scrap value of $375,000.

Option 2:

Replace the worn-out equipment with Eco-CNC equipment. The quoted price of this equipment is $17,800,000 payable in 5 equal installments of 3,560,000 starting at delivery. This equipment uses $96,000 of electricity a year. It has a service life of 5 years.It has a scrap value of $475,000.

Option 3:

Replace the worn-out equipment with Bargain Shack equipment. The quoted price of this equipment is $9,000,000 where half is payable upon delivery and the remainder is payable in 1 year after delivery. This equipment uses $135,000 of electricity a year. It has a service life of 5 years. It has a scrap value of $165,000.  

Assume that the discount rate is 6% and that electricity is paid at the end of each year. Calculate the net present value for each option and recommend the option that Over the River Bridge Company should take based on the net present value.

Answer 1

Let us first calculate NPV of each option

(Note - I am showing OUTFLOW as positive item. Lowest NPV would be better in this case)

Option 1

Year	Cash Flow	PV Factor	Present Value
0	$       16,500,000	1.000	$ 16,500,000
1	$            185,000	0.943	$       174,528
2	$            185,000	0.890	$       164,649
3	$            185,000	0.840	$       155,330
4	$            185,000	0.792	$       146,537
5	$            185,000	0.747	$       138,243
5	$           (375,000)	0.747	$      (280,222)
			$ 16,999,065

Option 2

Year	Cash Flow	PV Factor	Present Value
0	$         3,560,000	1.000	$    3,560,000
1	$              96,000	0.943	$          90,566
1	$         3,560,000	0.943	$    3,358,491
2	$              96,000	0.890	$          85,440
2	$         3,560,000	0.890	$    3,168,387
3	$              96,000	0.840	$          80,603
3	$         3,560,000	0.840	$    2,989,045
4	$              96,000	0.792	$          76,041
4	$         3,560,000	0.792	$    2,819,853
5	$              96,000	0.747	$          71,737
5	$           (475,000)	0.747	$      (354,948)
			$ 15,945,215

Option 3

Year	Cash Flow	PV Factor	Present Value
0	$   4,500,000	1.000	$    4,500,000
1	$      135,000	0.943	$       127,358
1	$   4,500,000	0.943	$    4,245,283
2	$      135,000	0.890	$       120,150
3	$      135,000	0.840	$       113,349
4	$      135,000	0.792	$       106,933
5	$      135,000	0.747	$       100,880
5	$     (165,000)	0.747	$      (123,298)
			$   9,190,655

Option 3 is the most cost effective