Re-equipment Problems (A) Equipment Replacement The Parsons Company is consideri

Question

Re-equipment Problems (A) Equipment Replacement The Parsons Company is considering the purchase of new equipment to perform operations currently being performed on different, less efficient equipment. The purchase price is $10,000,000, delivered and installed. A Parsons production engineer estimates that the new equipment will produce savings of $2,000,000 in labor and other direct costs annually, as compared with the present equipment. He estimated the proposed equipment's economic life at 12 years, with zero salvage value. The presente least 20 more years. The company requires a return of at least 20 percent before taxes on an investment of this type. Taxes are to be disregarded.

Explanation / Answer

Solution 1:

As per NPV of proposal is negative, therefore company should not replace equipment.

Solution 2:

As salvage value of present equipment is zero as on date, therefore it will not affect the propsal. The present equipment is having book value of $4,800,000 will not change the deceision as it is a sunk cost only.

Therefore in this case also NPV will remain the same as in solution 1, and proposal should be rejected.

Solution 3:

As this proposal will result in positive NPV, hence company should replace the present equipment.

Computation of NPV of Equipment replacment proposal Particulars Amount Period PV Factor Present Value Incremental Cash Outflows Purchase price of new machine $10,000,000.00 0 1 $10,000,000.00 Salvage value of old machine 0 0 1 $0.00 Net Increment cash out flows (A) $10,000,000.00 $10,000,000.00 Incremental Cash Inflows Annual cost savings $2,000,000.00 1 to 12 4.4392 $8,878,400.00 Net Increment cash Inflows (B) $8,878,400.00 NPV (B-A) -$1,121,600.00

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