Question

Pineapple Ltd is considering replacing its current stock of computers with a new model. It plans to evaluate three options
based on the following information:

Old Computer Model XA $20 000 $9000 p.a. Model XD $25 000 $9750 p.a. Model XXD $32 000 $10 000 p.a. $7000 p.a. $5000 $10 000 $12 500 $18 000 Item Cost Net cash flows Disposal value: at present Disposal value: in 2 years Disposal value: in 4 years Disposal value: in 8 years Estimated life Required rate of return (real) $8500 $10 500 $4000 2 years 10% p.a. 4 years 10% p.a. 8 years 10% p.a. 12 years 10% p.a.

Management is considering three options:
1. Replace the old computers now and operate Model XA for four years, then replace with Model XD and operate for eight
years, to be replaced in perpetuity
2. Replace the old computers now and operate Model XXD for 12 years, to be replaced in perpetuity
3. Replace the old computers now and undertake Model XA for three times its estimated life.
Which option should management choose?
A. Option 1
B. Option 2
C. Option 3
D. Indifferent between options 1 and 2

Answer 1

The Answer is A Option 1

Item

Model XA

Model XD

Model XXD

Net Cash Flows	9000	9750	10000
Cost	20000	25000	32000
Disposal Value in Year 2	-10000	-12500	-18000
	10000	12500	14000
Return on Inv	0.90	0.78	0.71

Since Model XA offers better Return on Investment hence Option 1 is preferable