MC Question 29
Ridag Co operates in an industry which has recently been deregulated as the government seeks to increase competition in the industry.
Ridag Co plans to replace an existing machine and must choose between two machines. Machine 1 has an initial cost of $200,000 and will have a scrap value of $25,000 after four years. Machine 2 has an initial cost of $225,000 and will have a scrap value of $50,000 after three years. Annual maintenance costs of the two machines are as follows:
| Year | 1 | 2 | 3 | 4 |
|---|---|---|---|---|
| Machine 1 ($ per year) | 25,000 | 29,000 | 32,000 | 35,000 |
| Machine 2 ($ per year) | 15,000 | 20,000 | 25,000 |
Where relevant, all information relating to this project has already been adjusted to include expected future inflation.
Taxation and tax allowable depreciation must be ignored in relation to Machine 1 and Machine 2.
Ridag Co has a nominal before-tax weighted average cost of capital of 12% and a nominal after-tax weighted average cost of capital of 7%.
Doubt has been cast over the accuracy of the year 2 and year 3 maintenance costs for Machine 2. On further investigation it was found that the following potential cash flows are now predicted:
| Year | Cash ($) | flow Probability |
|---|---|---|
| 2 | 18,000 | 0·3 |
| 2 | 25,000 | 0·7 |
| 3 | 23,000 | 0·2 |
| 3 | 24,000 | 0·35 |
| 3 | 30,000 | 0·45 |
What is the expected present value of the maintenance costs for year 3?
A. $26,500
B. $18,868
C. $21,624
D. $35,173