Interstate Manufacturing is considering either overhauling an old machine or replacing it with a new machine. Information about the two alternatives follows. Management requires a 10% rate of return on its investments.
Alternative 1: Keep the old machine and have it overhauled. This requires an initial investment of $150,000 and results in $50,000 of net cash flows in each of the next five years. After five years, it can be sold for a $15,000 salvage value.
Cost of old machine $111,000
Cost of overhaul 158,000
Annual expected revenues generated 106,000
Annual cash operating costs after overhaul 43,000
Salvage value of old machine in 5 years 16,000
Alternative 2: Sell the old machine for $29,000 and buy a new one. The new machine requires an initial investment of $300,000 and can be sold for a $20,000 salvage value in five years. It would yield cost savings and higher sales, resulting in net cash flows of $65,000 in each of the next five years.
Cost of new machine $291,000
Salvage value of old machine now 34,000
Annual expected revenues generated 94,000
Annual cash operating costs 22,000
Salvage value of new machine in 5 years 15,000
Required:
1. Determine the net present value of alternative 1.
2. Determine the net present value of alternative 2.
3. Which alternative should management select based on net present value?
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