Question

Hughes Corporation is considering replacing a machine used in the manufacturing process with a new, more efficient model. The purchase price of the new machine is $150,000 and the old machine can be sold for $100,000. Output for the two machines is identical; they will both be used to produce the same amount of product for five years. However, the annual operating costs of the old machine are $18,000 compared to $10,000 for the new machine. Also, the new machine has a salvage value of $25,000, but the old machine will be worthless at the end of the five years. You are deciding whether the company should sell the old machine and purchase the new model. You have determined that an 8% rate properly reflects the time value of money in this situation and that all operating costs are paid at the end of the year. For this initial comparison you ignore the effect of the decision on income taxes. 

 

Required: 

1. What is the incremental cash outflow required to acquire the new machine?

2. What is the present value of the benefits of acquiring the new machine?

Answer 1

1.

• If the same amount of installment is paid or received at the end or beginning of each period, such series of Cash Flows is referred to as Annuity.

• If the amount of annuity is paid or received at the end of each compounding period, it is known as Ordinary Annuity.

• The value of all such cash flows i.e. Ordinary Annuity as on present date is called Present Value of Ordinary Annuity.

• The formula for Present Value of Ordinary Annuity (PVA) is given by the formula:

 

PVA = FV*PVA of 1$.

where FV is the Future Value

and PVA of 1$ is given by the formula

 

 

i = Interest Rate

n = number of years compounded

 

Given,

Hughes Corporation is considering replacing machine.

The purchase price of new machine is $150,000 and old machine is sold for $100,000.

Annual operating costs of old machine are $18,000 compared to $10,000 for new machine.

Operating costs are paid at the end of each year.

New machine has salvage value of $25,000 but old machine will be worthless after 5 years.

Rate of interest is 8%.

 

Determine Incremental Cash Outflow required to acquire the New Machine.

• For determining the incremental cash outflow, consider cash inflows and cash outflows.

• Deduct Cash Inflows and Cash Outflows.

• Compare both alternatives.

 

Using the above concept,

 

The formulae for the above calculations are as follows:

 

Thus from the above computations,

Incremental Cash Outflow to acquire New Machine is $1,044.

 

Opting Old Machine is recommendable.

 

2.

Determination of the Present Value of Benefits of acquiring new machine.

 

The benefits for acquiring new machine shall be

• Savings in Annual Operating Costs

• Salvage Value at the end of 5th year

• Sale Value of Old Machine.

 

From the above table,

Savings in Annual Operating Costs is $31,941.68

Salvage Value at the end of 5th year is $17,014.58

Sale Value of Old Machine is $100,000

Summing up, the total is $148,956

 

Thus, the Present Value of benefits of acquiring New Machine is $148,956.

Thus, the Present Value of benefits of acquiring New Machine is $148,956.