Question

“I’m not sure we should lay out $300,000 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 $84,000 for software and installation, and another $48,000 per year just to maintain the thing. In addition, the manufacturer admits it would cost $47,000 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 $114,000 per year. And we would save another $7,500 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 17% required rate of return.”

“I’m still not convinced,” countered Mr. Alder. “We can only get $17,000 scrap value out of our old welding equipment if we sell it now, and in six years the new machine will only be worth $30,000 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 13B-1 and Exhibit 13B-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

Answer 1)

Annual net cost savings = saving of payment to six welders + saving on reduction in waste material – less annual maintenance costs

Annual net cost savings = $114000 + $7500 - $48000 = $73500

Answer 2a) Cash flows at time 0

Outflow: Cost of automated welding machine = $300000

Outflow: Software & installation costs = $84000

Inflow: Salvage Value of old machine = $17000

Net Cash flows at time 0 = -$300000 - $84000 + $17000 = -$367,000

Annual Cash flows = $73500 from time 1 to 6

Other cash flows associated with the project

Outflow: Replacement of worn out part at the end of year 3 = $47000

Inflow: Salvage Value at end the end of year 6 = $30000

Hence, NPV = -$367000 + 73500 * (P/A, 17%, 6) - $47000 * (P/F, 17%, 3) + 30000 * (P/F, 17%, 6)

NPV = -367000 + 73500 * 3.589185 – 47000 * 0.624371 + 30000 * 0.389839 = -$120,845.17

Answer 2b) Since, NPV of the automated welding machine is less than zero, purchasing of machine is not recommended.

Answer 3) If ‘A’ is the minimum dollar value of annual intangible benefits so that project is accepted, sum of PV of A at 17% discounting for 6 years and current NPV should be equal to zero.

i.e. A * (P/A, 17%, 6) – 120845.17 = 0

A = 120845.17/3.589185 = $33,669.25

i.e. $33,670 is the minimum dollar value of annual intangible benefits so that the project is accepted.