1.

Capital Budgeting: Replacement Decision

A machine purchased six years ago for $ 150000 has been depreciated to a book
value of $ 90000. It originally had a projected life of 15 years and zero salvage
value. A new machine will cost $ 250000 and result in a reduced operating cost of
$ 30000 per year for the next nine years. The older machine could be sold for $
50000. The cost of capital is 10%. The new machine will be depreciated on a
straight line basis over nine years life with $ 25000 salvage value. The company
tax rate is 55%. Determine whether the old machine should be replaced?

Problem: 9-20

Project A Project B
Initial $ 80000 $ 50000
Investment
Year Cash inflows
1 $15000 $15000
2 20000 15000
3 25000 15000
4 30000 15000
5 35000 15000

Requirements:

a. Calculate each projects payback period.

b. Calculate the net present value (NPV) for each project.
c. Calculate the internal rate of return (IRR) for each project.
d. Draw a net present value profile for each project on the same set of axes,
and discuss any conflict in ranking that may exist between NPV and IRR.
e. Summarize the preferences dictated by each measure, and indicate which
project you would recommend. Explain why?
Problem : 9-23

Certainty equivalents-Accept-reject decision: Allison Industries has

constructed a table, shown below, that gives expected cash inflows and
certainty equivalent factors for these cash inflows. These measures are for a
new machine with a 5-year life that requires an initial investment of $95000.
the firm has a 15% cost of capital, and risk-free rate is 10%.

Year Cash inflows Certainty Equivalent

factors
1 $35000 1.0
2 35000 .8
3 35000 .6
4 35000 .6
5 35000 .2

Requirements:

A. What is the net present value (unadjusted for risk)?

B. What is the certainty equivalent net present value?
C. Should the firm accept the project? Explain.
D. Management has some doubts about the estimate of certainty equivalent
factor for year 5. There is some evidence that it may not be any lower than
that for year 4. What impact might this have on the decision you
recommended C? Explain.