Question

The Palm Tree Café is considering to buy a new Coffee blending machine.

A relative of the manager suggests her an offer of a well-known brand:

Pricing at $300,000, it would generate an income of $90,000 annually. The offer includes the first-year maintenance service free of charge. So, the first annual maintenance service charge of $30,000 would be payable at the beginning of the second year.  Its life span can last for 6 years.  The salvage value would be $3,000.

Given that MARR is 10%.

To save some money, you suggest the manager to seek for third party maintenance service instead of the original manufacturer at the beginning of the second year, which charges $20,000 annually.  How would this suggestion influence the manager’s decision?

Answer 1

The decisive factor for both the cases will be depending upon whether the service charges @ 20,000 is to be paid every year for 6 years.

Or the second option is to take maintenance by manufacturer for which 30,000 will be charges every year for five years starting from second year.

The pricing in both the options is $ 3,00,000 and hence can be excluded. The income is $ 90,000 annually and salvage value after 6 years is also the same.

The only consideration is the two factors and where charges are low that will be accepted.

MARR is @ 10% annually.

For year 1 = 1

For year 2 = 1/1.1 = 0.9091

For year 3 = 0.9091/1.1 = 0.8264

For year 4 = 0.8264/1.1 = 0.7513

For year 5 = 0.7513/1.1 = 0.6830

For year 6 = 0.6830/1.1 = 0.6209

1) For service charges @ 20,000, total charges for six years will be as follows -

MARR is as calculated above -

Present value of service charges =20,000*(1+0.9091+0.8264+0.7513+0.6830+0.6209)

= 20,000 * 4.7907 = $ 95,815.73

2) For maintenance charges by manufacturer

Present value = 30,000 * (0.9091+0.8264+0.7513+0.6830+0.6209)

= 30,000 * 3.7907

= $ 113,723.60

The charges are lower when given to service provider and hence that should be accepted.

Thus machine to be brought from manufacturer but servicing to be done by service provider.

Note -

Rounding off to four figures has been done. Answer will change if different rounding off is followed. However, difference will be nominal.

Also, it is given that manufacturer will charge 30,000 at beginning of second year and hence PV factor has been taken as same as end of first year.