Question

“I’m not sure we should lay out $265,000 for that automated welding machine,” said Jim Alder, president of the Superior Equipment Company. “That’s a lot of money, and it would cost us $78,000 for software and installation, and another $40,800 per year just to maintain the thing. In addition, the manufacturer admits it would cost $41,000 more at the end of three years to replace worn-out parts.”

“I admit it’s a lot of money,” said Franci Rogers, the controller. “But you know the turnover problem we’ve had with the welding crew. This machine would replace six welders at a cost savings of $108,000 per year. And we would save another $6,900 per year in reduced material waste. When you figure that the automated welder would last for six years, I’m sure the return would be greater than our 19% required rate of return.”

“I’m still not convinced,” countered Mr. Alder. “We can only get $14,000 scrap value out of our old welding equipment if we sell it now, and in six years the new machine will only be worth $24,000 for parts. But have your people work up the figures and we’ll talk about them at the executive committee meeting tomorrow.”

Click here to view Exhibit 12B-1 and Exhibit 12B-2, to determine the appropriate discount factor(s) using tables.

Required:

1. Compute the annual net cost savings promised by the automated welding machine.

2a. Using the data from (1) above and other data from the problem, compute the automated welding machine’s net present value.

2b. Would you recommend purchasing the automated welding machine?

3. Assume that management can identify several intangible benefits associated with the automated welding machine, including greater flexibility in shifting from one type of product to another, improved quality of output, and faster delivery as a result of reduced throughput time. What minimum dollar value per year would management have to attach to these intangible benefits in order to make the new welding machine an acceptable investment?

Answer 1

1	Annual net cost savings:
					$
	Welders cost				108000
	Material waste				6900
	Maintenance cost				-40800
	Annual net cost savings				74100
2a.	Discount rate=Required rate of return=19%
	Net present value:
	Year	Outflow	Cost savings	Net cash flow	PV factor at 19%	Present value
		a	b	c=b-a	d	c*d
	0	343000	14000	-329000	1	-329000
		(265000+78000)
	1	40800	114900	74100	0.84034	62269
	2	40800	114900	74100	0.70616	52327
	3	81800	114900	33100	0.59342	19642
		(40800+41000)
	4	40800	114900	74100	0.49867	36951
	5	40800	114900	74100	0.41905	31052
	6	40800	138900	98100	0.35214	34545
			(114900+24000)
	Net present value					-92214
2b.	No,Since the NPV is negative.
3	In order to be an acceptable investment,NPV should be atleast 0.
	Minimum dollar value per year=Maintenace cost per year=x
	Net present value:
	Year	Outflow	Cost savings	Net cash flow	PV factor at 19%	Present value
		a	b	c=b-a	d	c*d
	0	343000	14000	-329000	1	-329000
	1	x	114900	114900-x	0.84034	96554.62-0.84034x
	2	x	114900	114900-x	0.70616	81138.34-0.70616x
	3	x+41000	114900	73900-x	0.59342	43853.43-0.59342x
	4	x	114900	114900-x	0.49867	57297.04-0.49867x
	5	x	114900	114900-x	0.41905	48148.77-0.41905x
	6	x	138900	138900-x	0.35214	48912.57-0.35214x
	Net present value					0
	96554.62-0.84034x+81138.34-70616x+43853.43-0.59342x+57297.04-0.49867x+48148.77-0.41905x+48912.57-0.35214x-329000=0
	46904.77-3.40978x=0
	3.40978x=46904.77
	x=46904.77/3.40978=$ 13755.95=$ 13756
	Minimum dollar value per year=$ 13756