Interstate Manufacturing is considering either replacing one of its old machines with a new machine or having the old machine overhauled. Information about the two alternatives follows. Management requires a 10% rate of return on its investments.
Alternative 1: Keep the old machine and have it overhauled. If the old machine is overhauled, it will be kept for another five years and then sold for its salvage value.
Cost of old machine . . . . . . . . . . . . . . . . . . . . . . . . $112,000
Cost of overhaul . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000
Annual expected revenues generated . . . . . . . . . . . . . 95,000
Annual cash operating costs after overhaul . . . . . . . . 42,000
salvage value of old machine in 5 years . . . . . . . . . . . 15,000
Alternative 2: Sell the old machine and buy a new one. The new machine is more efficient and will yield substantial operating cost savings with more product being produced and sold.
Cost of new machine . . . . . . . . . . . . . . . . . . . . . $300,000
salvage value of old machine now . . . . . . . . . . . . 29,000
Annual expected revenues generated . . . . . . . . . 100,000
Annual cash operating costs . . . . . . . . . . . . . . . . . 32,000
salvage value of new machine in 5 years . . . . . . . 20,000
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.