Tulsa Company is considering investing in new bottling equipment and has two opt

Question

Tulsa Company is considering investing in new bottling equipment and has two options: Option A has a lower initial cost but would require a significant expenditure to rebuild the machine after four years; Option B has higher maintenance costs, but also has a higher salvage value at the end of its useful life. Tulsa’s cost of capital is 11 percent. The following estimates of the cash flows were developed by Tulsa’s controller:

Use these links to calculate NPV:

http://lectures.mhhe.com/connect/0077493699/table11_1a.JPG

http://lectures.mhhe.com/connect/0077493699/table_11_2a.jpg

http://lectures.mhhe.com/connect/0077493699/table11_3A.JPG

http://lectures.mhhe.com/connect/0077493699/table11_4a.JPG

Fill in table.

Option A Option B   Initial investment $ 320,000 $ 454,000   Annual cash inflows 150,000 160,000   Annual cash outflows 70,000 75,000   Costs to rebuild 120,000 0   Salvage value 0 24,000   Estimated useful life 8 years 8 years

Explanation / Answer

1

Calculation of NPV:

Option A:

Table or calculator function:

n=

$                 8.00

i=

$              11.00

%

Cash Flows

Cash Flows

Discount Factor

Present value

A

B

A*B

Annual Cash Flows = (150000-70000)

$      80,000.00

                   5.1461

$        411,688.00

Cost to Rebuild after 4 years

$ (120,000.00)

                   0.6587

$        (79,044.00)

Salvage after 8 years

$                     -  

                   0.4339

$                         -  

Capital Investment

$ (320,000.00)

1

$     (320,000.00)

Net Present value

$          12,644.00

Option B:

Table or calculator function:

n=

$                 8.00

i=

$              11.00

%

Cash Flows

Cash Flows

Discount Factor

Present value

A

B

A*B

Annual Cash Flows = (160000-75000)

$      85,000.00

                   5.1461

$        437,418.50

Cost to Rebuild after 4 years

$                     -  

                   0.6587

$                         -  

Salvage after 8 years

$      24,000.00

                   0.4339

$          10,413.60

Capital Investment

$ (454,000.00)

1

$     (454,000.00)

Net Present value

$          (6,167.90)

2

Tulsa should accept option A , because it gives higher NPV.

1

Calculation of NPV:

Option A:

Table or calculator function:

n=

$                 8.00

i=

$              11.00

%

Cash Flows

Cash Flows

Discount Factor

Present value

A

B

A*B

Annual Cash Flows = (150000-70000)

$      80,000.00

                   5.1461

$        411,688.00

Cost to Rebuild after 4 years

$ (120,000.00)

                   0.6587

$        (79,044.00)

Salvage after 8 years

$                     -  

                   0.4339

$                         -  

Capital Investment

$ (320,000.00)

1

$     (320,000.00)

Net Present value

$          12,644.00

Option B:

Table or calculator function:

n=

$                 8.00

i=

$              11.00

%

Cash Flows

Cash Flows

Discount Factor

Present value

A

B

A*B

Annual Cash Flows = (160000-75000)

$      85,000.00

                   5.1461

$        437,418.50

Cost to Rebuild after 4 years

$                     -  

                   0.6587

$                         -  

Salvage after 8 years

$      24,000.00

                   0.4339

$          10,413.60

Capital Investment

$ (454,000.00)

1

$     (454,000.00)

Net Present value

$          (6,167.90)

2

Tulsa should accept option A , because it gives higher NPV.

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