Reference no: EM132802165
Problem - Cost Chips is a manufacturer of elite speed microchips based in Omaha, Nebraska. Next year, in 2021, Cost Chips expects to deliver 700 elite speed microchips at an average price of $50,000. The plant cannot produce these elite speed microchips annually in the plant's current condition. To meet future demand, Cost Chips must either modernize the plant or replace it. The old equipment is fully depreciated and can be sold for $4,010,000 if the plant is replaced. If the plant is modernized, the costs to modernize it are to be capitalized and depreciated over the useful life of the updated plant. The old equipment is retained as part of the modernize alternative. The following data on the two options are available:
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Modernize
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Replace
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Initial Investment in 2021
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$36,800,000
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$61,700,000
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Terminal Disposal Value in 2028
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$7,000,000
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$17,000,000
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Useful Life
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8 Years
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8 Years
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Total annual cash variable costs per microchip
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$35,500
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$26,000
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Cost Chips uses straight-line depreciation, assuming zero terminal disposal value. For simplicity, we assume no change in prices or costs in future years. The investment will be made at the beginning of 2021, and all transactions thereafter occur on the last day of the year. Cost Chips' required rate of return is 11%.
Cost Chips has a special waiver on income taxes until 2029.
Required -
1. Calculate net present value of the modernize and replace alternatives.
2. Which alternative should Cost Chips choose?
3. What factors should Cost Chips consider in choosing between the alternatives?
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