Question

The Managerial Accounting Department at your company has been engaged by the Production Department for assistance in evaluating a purchase decision. The equipment the production department is currently utilizing is outdated and has become costly to maintain. New machines would also provide increased efficiencies leading to increased sales. Due to this, the department is considering replacing all equipment with new machines. Data: - Cost of Current Machines: $800,000 - Cost of New Machines: $1,250,000 - Annual Maintenance on Current Machines: $125,000 - Annual Maintenance on New Machines: $54,000 - Salvage Value of Current Machines: $325,000 - Immediate employee training cost on new machines: $15,000 - Working Capital needed for new machines: $50,000 - Would be needed once machines are purchased and working capital released after 5 years - Increased sales opportunity provided by new machines: $200,000 first year and growing at 5% per year after - Company’s Required Rate of Return: 10% - Contribution margin: 47% - Depreciation and income taxes should be ignored.  

Answer 1

Step 1 :- Initial Investment

• Cost of new machine $ 1250000
• Employee Training costs $ 15000
• Working Capital $ 50000
• Salvage value of current machine released $ 325000

Total Initial Investment = $ 990000 (1250000+15000+50000-325000)

Step 2 :- Present value of Savings and increased sales

• Savings in annual maintenance (125000-54000) = $ 71000

  • Year	Savings in Maintenance cost	Increased contribution	Working capital	DF @ 10%	Present Value
    1	71000	94000 (200000*47%)	-	0.9091	150001
    2	71000	98700	-	0.8264	140240
    3	71000	103635	-	0.7513	131203
    4	71000	108817	-	0.6830	122815
    5	71000	114258	50000	0.6209	146072

• Total Present value of all savings and contribution = $ 690331, whereas investment to be made is $ 990000
• Hence the new machine should not be purchased