Reference no: EM132873195
ABC Manufacturing expects to sell 1,025 units of product in 2022 at an average price of $100,000 per unit based on current demand. The Chief Marketing Officer forecasts growth of 50 units per year through 2026. So, the demand will be 1,025 units in 2022, 1,075 units in 2023, etc. and the $100,000 price will remain consistent for all five years of the investment life. However, ABC cannot produce more than
1,000 units annually based on current capacity.
In order to meet demand, ABC must either update the current plant or replace it. The old equipment is fully depreciated and can be sold for $4,000,000 if the plant is replaced. If the plant is updated, the costs to update it would be capitalized and depreciated over the useful life of the updated plant. If the plant is updated, then the old equipment would be retained.
The following table summarizes the projected data for both options:
Update Replace
Initial investment in 2022 $80,000,000 $120,000,000
Terminal disposal value in 2026 $5,000,000 $20,000,000
Useful life 5 years 5 years
Total annual cash operating costs per unit $75,000 $62,000
ABC uses straight-line depreciation, assuming zero terminal disposal value. Assume no changes in prices or costs during future years. The investment will be made at the beginning of 2022 and all cash flows after that are assumed to occur on the last day of each year. ABC's required rate of return is 18%.
Assume an income tax rate of 20%. Proceeds from sales of equipment above book value are taxed at the same 20% rate.
Required:
Question 1. Using Excel functions, calculate the net present value and the project profitability index (PPI) for the update and replace alternatives.
Question 2. Using Excel functions, calculate the internal rate of return for both the update and replace alternatives.
Question 3. Calculate the payback period for the update and replace alternatives.
Question 4. Based on the results, which option should ABC choose? Specifically explain why.