Replacement chain and equivalent annual annuity

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Reference no: EM132000105

Il Parlo Company (IPC) is planning to purchase one unit of new heavy duty concrete pump. The company currently encounters a severe capital rationing, so it can afford to invest in only one unit. The production manager of the company, Ms. Claudia Massari has narrowed the choice down to two options: HDBS pump and Reed Booster pump.

HDBS pump requires an initial cash outflow of $100,000, which then generates positive after-tax cash flows of $65,000 at the end of each of the next two years. The HDBS pump can be replaced with the identical model every two years while the cash inflows and outflow remaining the same.

Reed Booster pump also requires an initial cash outflow of $100,000 to generate positive after-tax cash flows of $50,000 at the end of each of the next three years. Reed Booster pump can be replaced every three years, but each time that it is replaced, both the cash inflows and outflows increase by 10 percent.

The company must have concrete pump for the six years, after which time the company plans on closing the driveway construction division of the company, at the end of the six year both pumps have not market values. IPC uses a weighted average cost of capital of 12 percent for both projects.

A) Which project do you advise the IPC to purchase using NPV, without adjustment for life difference?

B) To adjust for their life difference, you use the replacement chain and Equivalent Annual Annuity (EAA). Which project do you advise the IPC to pick now?

C) Which pump creates the most value to the company? Why? Please explain in 4 lines.

Reference no: EM132000105

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