Your company is evaluating two different mutually exclusive copier systems for y

Question

Your company is evaluating two different mutually exclusive copier systems for your front office. You plan to need copier services for a total of 8 years. The following costs associated with each alternative.

Alternative 1: Initial cost of $7,000. Cost in year 1 is $2,500, cost in year 2 is $2,000, and costs in years 3 through 6 are $1,500 each year.

Alternative 2: Initial cost of $5,000. Costs in years 1 through 7 are $2,000 each year.

Your company will lease comparable equipment for the remaining years of the required service period for each alternative at a cost of $3,000 per year.

If your company’s minimum attractive rate of return is 10%, which alternative do you recommend and why

Explanation / Answer

It is a problem on capital investment. Firm is going to invest in a copier. The life of the machine is 8 years. It will be invested at some initial cost.Subsequently there will be some annual expenses for 3 years. From 4th year it can be leased to earn some cash inflows.

Here two alternative machines are available. You have to invest in one of them. The computation process is explained below:

1. First ascertain present value of cash flows. It is the current money value of future flows. It is calculated by multiplying cash flows with a discounting factor. In discounting factor you have to use minimum required return of 10% as discounting rate. It will ensure that required rate of return is earned.

2. Now sum the present value of each years inflows/outflows. Deduct initial cash flow from it to get net present value of cash flows.

3. Accept the project which will give you highest net present value.

Calculation of present value of first machine:

Now in the similar manner you can estimate present value of cash flows of machine 2. It is shown below:

Result:

Now compare the presernt value of total cash flow. For first machine it is outflow of $11,916. For 2nd machine it is an outflow of $13,337. So first one is recommended as it has lower cash outflow.

Statement showing present value of cash flows from the machine 1 Details Years 1 2 3 4 5 6 7 8 Total Cash flows ($2,500) ($2,000) ($1,500) ($1,500) ($1,500) ($1,500) $3,000 $3,000 ($4,500) Discount factor at 10% 0.90909 0.82645 0.75131 0.68301 0.62092 0.56447 0.51316 0.46651 $5 Present value -2272.7 -1652.9 -1127 -1024.5 -931.38 -846.71 1539.47 1399.52 ($4,916) Add: initial cost ($7,000) Total present value of life time cash flows. ($11,916)

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