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Evaluation of Projects with Unequal Lives Replacement Chain Approach(RC) Equivalent annual Annuity Approach(EAA) Evaluation of Projects with Unequal...

The management of Casilla Manufacturing Company (CMC) has decided to invest in a new robotic system to increase the productivity of the company. The company has enough money to invest in one system, and has narrowed the choice down to Asea System and Bsea System.

Asea System requires an up-front cost of $100,000 and then generates positive after-tax cash flows of $60,000 at the end of each of the next two years. The Asea system can be replaced every two years with the cash inflows and outflows remaining the same.


Bsea System also requires an up-front cost of $100,000 and then generates positive after-tax cash flows of $48,000 at the end of each of the next three years. Bsea System can be replaced every three years, but each time the system is replaced, both the cash inflows and outflows increase by 10 percent.


The company needs a system for the six years, after which time the management plans on liquidating the company. The company's cost of capital is 11 percent.


What is the NPV of each system (on a six-year extended basis)? Which system creates the most value to the company?


Show your work step by step. Please be clean and neat.


Explain, in words, the approach that you have used to solve this problem in 5 lines.


Hint: Read the notes related to “the evaluation of projects with unequal lives”. The note has been attached.

Evaluation of Projects with Unequal Lives Replacement Chain Approach(RC) Equivalent annual Annuity Approach(EAA) Evaluation of Projects with Unequal Lives When evaluating mutually exclusive projects that have unequal lives, the capital budgeting decisions become more complex. Consider the following projects involving investments on two different machines: Year Machine F I 0 =$5,000 Machine G I 0 =$9,000 1 $3,300 $3,000 2 $3,300 $3,000 3 $3,300 $3,000 4 0.00 $3,000 5 0.00 $3,000 6 0.00 $3,000 Where the WACC = K = 10% for both projects. We calculate i n t t i t i I K CF NPV 0 1 ) 1 ( 1
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such that i = (F, G) NPV F = $3,207 NPV G = $4,066 If we assume neither machine would be replaced after its useful life has been finished, selection of the machine with highest NPV would be appropriate. In this case machine G. However, if production and sales of the product is expected to continue forever, machine F will be needed to be replaced after three years. This additional investment and the cash flow it generates during years 3 to 6 must be included in the evaluation of this mutually exclusive situation. This means that the comparison of the NPV generated by machine G over a 6-year period against the NPV generated by machine F over only a 3-year period would be unfair to machine F. To solve this problem, we construct a replacement chain for machine F. To construct a replacement chain, it is assumed that in the last year of machine F’s expected productive life; second initial cash out flow is incurred for the purchase of a new machine F to replace the old one. The new replacement machine will generate another 3 years of the same cash flows: 2
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