Question

They are currently using several old-style machines that together had cost $700,000. Depreciation of $220,000 has already been charged against this total cost; depreciation charges are $80,000 annually. Management believes these machines will need to be replaced after eight more years. They have a current market value of $205,000. The old machines require eleven workers per shift earning $14.50/hr plus three maintenance workers paid $13.50/hr. The plant operates day and afternoon shifts five days each week; maintenance workers are assigned to the afternoon shift only. Maintenance expenses have been running at $5,500 annually; the cost of electricity has been $26,000 per year. The production process is not only labor intensive, but also physically demanding. Workplace injuries are not uncommon and lately medical claims have been increasing. The Machine Tool Division is considering the purchase of a piece of highly-automated, robotic production equipment. It would replace older machines and would offer improvements in quality, and some additional capacity for expansion. Because of the magnitude of the proposed expenditure, a careful estimate of the projects costs and benefits is needed. The new machine will have a total cost that includes shipping, installation and testing of $1.5 million. The plant will also need $350,000 in modifications to accommodate the new machine. These costs will be capitalized and depreciated over the eight-year estimated life of the machine. The new machine would require only two skilled operators (one per shift) who would earn $25/hr. Maintenance will be outsourced and cost $90,000 per year. The annual cost of electricity is estimated to be $50,000.

b. Identify and analyze the relevant cash flows for the two alternatives - buying the new machine vs. continuing to use the old ones.

Answer 1

b - Relevant cash flows for the two alternatives:

Cash Outflow - continue to use old machines	Amount	Amount
Labour to operate machine [a]		$     747,760
11 workers per shift*2 shifts*$14.5/hr*8hrs*5 days a week*52 weeks	$     663,520
3 workers*13.5/hr*8 hrs*5 days* 52 weeks	$        84,240
Maintenance expenses [b]		$          5,500
Electricity cost [c]		$        26,000
Annual charge [d] = [a+b+c]		$     779,260
Total cash outflow when old machines are continued [d*8]		$ 6,234,080

Cash Outflow - Purchase new machine	Amount
Salvage value of old machine	$   (205,000)
New machine shipping, installation, testing cost	$ 1,500,000
Plant modification charge	$     350,000
Total one-time charge [a]	$ 1,645,000
Annual maintenance [b]	$        90,000
Electricity [c]	$        50,000
Skilled labour [d]	$     104,000
1 worker per shift*2 shifts*$25/h r*8 hrs*5 days*52 weeks
Annual charges for 8 years [e] = [b+c+d]*8	$ 1,952,000
Total cost for purchasing new machine and operating it [a+e]	$ 3,597,000

Note: One shift is assumed as 8 hours.

From the above two tables, it is seen that the cash outflow from purchasing a new machine is considerably less than continuing with the old machines ($ 2.6 milliion less) and based on this analysis, purchasing the new machine is recommended. However time value of money and non-cash costs have not been considered in this analysis.