Question

Business Case:
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 The equipment the production department is currently utilizing is outdated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.

1. Explain to me the decision you are assisting the department with and at a high level and
how you will assist.
2. Define in your own words: Relevant Costs/Revenues (look to previous chapters to assist), Net Present
Value, Internal Rate of Return, and Contribution Margin.
3. Identify and list the relevant costs and revenues to be included in the decision. For this week you only
need to list the name or description of the expense.

Answer 1

1-	This decision will come under replacement and modernization decision of capital budgeting. In which new more efficient equipment would be purchased and outdated and old equipment would be replaced. Under this type of decisions a incremental approach is followed by analysing the incremtnal cost incurred, incremental revenue & savings and reduction in cost. Under this type of decisions incremental net operating savings are discounted at a WACC and differenc between incremental investment and sum of present value of operating savings are calculated.if the difference is positive then we shall have a positive NPV and decision would be made otherwise, it would be dropped.
2-	relevent cost refers to the cost which plays a very important role in capital budgeting decisions. Sunk cost & finance costs are gernerally avoided in capital budgeting decisions
	relevent revenue refers to the revenue that is considered while making capital budgeting like incremental saving due to cost reduction, incremental revenue due to decision etc
	NPV = net present value it refers to excess of sum of discounted cash flow over the discounted cash outflow. It is the excess of benefits over the cost
	IRR = refers to internal rate of return at which NPV is zero. It is the rate at which sum of present value of cash inflow equal to cash outflow
	contribution margin refers to excess of sales or revenue over the variable cost of goods sold
3-	relevant cost to be considered
	1-	cost of new machine
	2-	book value of old machine
	3-	annual maintenance on old machine
	4-	annual maintenance on new machine
	5-	investment in working capital
	relevant revenue
	1-	increased sales revenue
	2-	scrap value of old machine
	3-	recovery of working capital
	4-	salvage value of new machine
	5-	savings in maintenance