Question

Pucker Distributors handles the warehousing of perishable foods and is considering replacing one of it primary cold storage units. The company had previously hired a consultant at a cost of $25,000 to study the feasibility of replacing its cold storage unit.

One vendor has offered to sell Pucker a cold storage unit for $250,000 with an expected life of 10 years. The unit is projected to reduce electricity costs over the current unit by $50,000 per year. However, it requires a $20,000 refurbishing every two years, beginning two years after purchase. The value of the unit at the end of 10 years is $5,000.

Another vendor has offered to sell Pucker a cold storage unit with similar capabilities for $300,000 and also with an expected life of 10 years. It will produce the same savings in electricity costs, but requires refurbishing every five years at a cost of $40,000. The value of the unit at the end of 10 years is $10,000.

Pucker's cost of capital is 8.5%.

Also, please answer the following questions:

Use a Net Present Value (NPV) analysis to determine which cold storage unit Pucker should select.

What does the NPV tell you about the project's acceptability?

What is the payback and the internal rate of return for each option?

From what little you know about the company Pucker, do you feel that the 8.5% cost of capital is appropriate for this project?

What potential risks could you foresee related to this replacement project and how could you mitigate those risks?

Answer 1

Since company has "previously" hired a consultant it is a "Sunk Cost" and it will not be taken into consideration. Also, even if we do it is common cost so it is expended in any scenario.

Comparison of NPV of 2 vendors is as below: (Note: Assuming that either units will be sold in 10th year, refurbishing cost will not be incurred at the end of 10th year)

Year	Particulars	Vendor 1	NPV @ 8.5%	Vendor 2	NPV @ 8.5%
0	Cost of Cold storage unit	-250,000	-250,000	-300,000	-300,000
1	Savings in electricity cost	50,000	46,083	50,000	46,083
2	Savings in electricity cost	50,000	42,473	50,000	42,473
2	Refurbishing cost	-20,000	-16,989	-	-
3	Savings in electricity cost	50,000	39,145	50,000	39,145
4	Savings in electricity cost	50,000	36,079	50,000	36,079
4	Refurbishing cost	-20,000	-14,431	-	-
5	Savings in electricity cost	50,000	33,252	50,000	33,252
5	Refurbishing cost	-	-	-40,000	-26,602
6	Savings in electricity cost	50,000	30,647	50,000	30,647
6	Refurbishing cost	-20,000	-12,259	-	-
7	Savings in electricity cost	50,000	28,246	50,000	28,246
8	Savings in electricity cost	50,000	26,033	50,000	26,033
8	Refurbishing cost	-20,000	-10,413	-	-
9	Savings in electricity cost	50,000	23,994	50,000	23,994
10	Savings in electricity cost	50,000	22,114	50,000	22,114
10	Salvage Value of unit	5,000	2,211	10,000	4,423
	Net Present value		26,186		5,888

Thus, option from vendor 1 is better owing to higher NPV.