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 $75,000 for software and installation, and another $37,200 per year just to maintain the thing. In addition, the manufacturer admits it would cost $38,000 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 $105,000 per year. And we would save another $6,600 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 $12,500 scrap value out of our old welding equipment if we sell it now, and in six years the new machine will only be worth $21,000 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 7B-1 and Exhibit 7B-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
Reduction in labor costs	105000
Reduction in material waste	6600
Total	111600
Less increased maintenance costs	37200
Annual net cost savings	74400
2a
	Now	1	2	3	4	5	6
Cost of machine	-265000
Software and installation	-75000
Salvage value of old equipment	12500
Annual net cost savings		74400	74400	74400	74400	74400	74400
Replacement of parts				-38000
Salvage value of new machine							21000
Total cash flows	-327500	74400	74400	36400	74400	74400	95400
Discount factor (19%)	1	0.840	0.706	0.593	0.499	0.419	0.352
Present value	-327500	62496	52526	21585	37126	31174	33581
Net present value	-89012
2b
NO, as Net Present value is negative
3
Negative Net present value to offset	89012
Divide by PV factor	3.410	=(1-(1.19)^-6)/0.19
Annual intangible benefits	26103	or 26111