Archer Foods has a freezer that is in need of repair and is considering whether to replace the old freezer with a new freezer or have the old freezer extensively repaired. Information about the two alternatives follows. Management requires a 10% rate of return on its investments.
Alternative 1: Keep the old freezer and have it repaired. If the old freezer is repaired, it will be kept for another 8 years and then sold for its salvage value.
Cost of old freezer . . . . . . . . . . . . . . . . . . . . . . . $75,000
Cost of repair . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Annual expected revenues generated . . . . . . . . . 63,000
Annual cash operating costs after repair . . . . . . . 55,000
salvage value of old freezer in 8 years . . . . . . . . . 3,000
Alternative 2: Sell the old freezer and buy a new one. The new freezer is larger than the old one and will allow the company to expand its product offerings, thereby generating more revenues. Also, it is more energy efficient and will yield substantial operating cost savings.
Cost of new freezer . . . . . . . . . . . . . . . . . . . . . $150,000
salvage value of old freezer now . . . . . . . . . . . . . 5,000
Annual expected revenues generated . . . . . . . . . 68,000
Annual cash operating costs . . . . . . . . . . . . . . . . 30,000
salvage value of new freezer in 8 years . . . . . . . . 8,000
Required
1. Determine the net present value of alternative 1.
2. Determine the net present value of alternative 2.
3. Which alternative do you recommend that management select? Explain.