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1) A lumber company that cuts fine woods for cabinetry is evaluating whether it

ID: 350485 • Letter: 1

Question

1) A lumber company that cuts fine woods for cabinetry is evaluating whether it should retain the current bleaching system or replace it with a new one. The relevant costs for each system are known or estimated. Use an interest rate of 10% per year to (a)perform the replacement analysis and (b) determine the minimum resale price needed to make the challenger replacement choice now. Is this a reasonable amount to expect for the current system?

Current

New

System

System

First cost 7 years ago, $

–450,000

First cost, $

–700,000

Remaining life, years

5

10

Current market value, $

50,000

AOC, $ per year

–160,000

–150,000

Future salvage, $

0

50,000

Current

New

System

System

First cost 7 years ago, $

–450,000

First cost, $

–700,000

Remaining life, years

5

10

Current market value, $

50,000

AOC, $ per year

–160,000

–150,000

Future salvage, $

0

50,000

Explanation / Answer

(a) Replacement analysis

Compound interest factors,

(P/A,10%,5) = ((1+10%)5-1)/(10%*(1+10%)5) = 3.791

(P/A,10%,10) = ((1+10%)10-1)/(10%*(1+10%)10) = 6.145

(A/P,10%,5) = 10%*(1+10%)5/((1+10%)5-1) = 0.2638

(A/P,10%,10) = 10%*(1+10%)10/((1+10%)10-1) = 0.1627

(P/F,10%,10) = 1/(1+10%)10 = 0.3855

Annual Worth (AW) of current system = -160000

Annual Worth (AW) of New system = (-700000+50000)*(A/P,10%,10) - 150000 + 50000*(P/F,10%,10)*(A/P,10%,10) =

= (-700000+50000)*0.1627 - 150000 + 50000*0.3855*0.1627 = -252619

AW of Current system is better, therefore, the current system should not be replaced by the new system

(b) The minimum resale price needed to make the challenger replacement choice = (-160000+150000-50000*0.3855*0.1627)/0.1627+700000 = $ 619,262

This is a very high amount and therefore, not reasonable to expect for the current system.