Westland College has a telephone system that is in poor condition. The system either can be overhauled or replaced with a new system. The following data have been gathered concerning these two alternatives (Ignore income taxes.) : Click here to view Exhibit 14B-1 and Exhibit 14B-2, to determine the appropriate discount factor(s) using the tables provided.Westland College uses a 10% discount rate and the total cost approach to capital budgeting analysis. Both alternatives are expected to have a useful life of eight years. The working capital would be released for use elsewhere when the project is completed.The net present value of the alternative of purchasing the new system is closest to:

A) $(1,076,495)
B) $(1,236,495)
C) $(1,169,895)
D) $(969,895)

Question

Westland College has a telephone system that is in poor condition. The system either can be overhauled or replaced with a new system. The following data have been gathered concerning these two alternatives (Ignore income taxes.) :

Click here to view Exhibit 14B-1 and Exhibit 14B-2, to determine the appropriate discount factor(s) using the tables provided.Westland College uses a 10% discount rate and the total cost approach to capital budgeting analysis. Both alternatives are expected to have a useful life of eight years. The working capital would be released for use elsewhere when the project is completed.The net present value of the alternative of purchasing the new system is closest to:

A) $(1,076,495)
B) $(1,236,495)
C) $(1,169,895)
D) $(969,895)

Sylvia Aneequa · Accepted Answer

Final Answer : B, Explanation :  To calculate the net present value (NPV) of each alternative, we need to find the present value of cash inflows and cash outflows, and subtract the two.For Option 1 (overhauling the system):Cash outflow = $4,000,000Cash inflows:Year 1: $1,000,000Year 2: $1,500,000Year 3: $2,000,000Year 4: $2,500,000Year 5: $2,500,000Year 6: $2,000,000Year 7: $1,500,000Year 8: $1,000,000Using the present value of an annuity table, we can find the present value of cash inflows to be $13,202,304.NPV = -$4,000,000 + $13,202,304 = $9,202,304For Option 2 (replacing the system):Cash outflow = $15,000,000Cash inflows:Year 1: $5,000,000Year 2: $5,000,000Year 3: $5,000,000Year 4: $5,000,000Year 5: $5,000,000Year 6: $5,000,000Year 7: $5,000,000Year 8: $5,000,000Using the present value of an annuity table, we can find the present value of cash inflows to be $29,236,799.NPV = -$15,000,000 + $29,236,799 = $14,236,799Therefore, the net present value of purchasing the new system is $14,236,799, which is closest to option B. The best choice is to replace the system.

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