XYZ manufacturing company wants to determine whether it should upgrade a class o
ID: 1122743 • Letter: X
Question
XYZ manufacturing company wants to determine whether it should upgrade a class of machines now or later. If the company selects plan A, the upgrade will be purchased now for $200,000. However, if the company selects plan B, the purchase will be deferred for 3 years when the cost is expected to rise to $300,000. XYZ expects a real MARR of 12% per year. The inflation rate in the country has averaged 3% per year. From only an economic perspective, determine whether the company should purchase now or later (a) when inflation is not considered and (b) when inflation is considered
Explanation / Answer
(a)
When inflation is not considered -
Plan A - The upgrade will be purchased now for $200,000
The present value of Plan A is $200,000
Plan B - The upgrade will be purchased after 3 years
Cost after three years = $300,000
MARR = 12%
Time period = 3 years
Calculate Present Value -
PV = $300,000 (P/F, 12%, 3) = $300,000 * 0.7118 = $213,540
The present value of Plan B is $213,540.
Based on present value, upgrade will cost less if undertaken now.
So, Company should purchase the upgrade now.
(b)
When inflation is considered -
Plan A - The upgrade will be purchased now for $200,000
The present value of Plan A is $200,000
Plan B - The upgrade will be purchased after 3 years
Cost after three years = $300,000
Interest rate = MARR + Inflation rate = 12% + 3% = 15%
Time period = 3 years
Calculate Present Value -
PV = $300,000 (P/F, 15%, 3) = $300,000 * 0.6575 = $197,250
The present value of Plan B is $197,250.
Based on present value, upgrade will cost less if undertaken three years later.
So, Company should purchase the upgrade later.
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