Question

“I’m not sure we should lay out $340,000 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 $92,000 for software and installation, and another $57,600 per year just to maintain the thing. In addition, the manufacturer admits it would cost $55,000 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 $122,000 per year. And we would save another $8,300 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 13% required rate of return.”

“I’m still not convinced,” countered Mr. Alder. “We can only get $21,000 scrap value out of our old welding equipment if we sell it now, and in six years the new machine will only be worth $38,000 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

Solution 1:

Computation of annual cost saving promised by Welding machine
Particulars	Amount
Cost saving due to repalcement of welders	$122,000.00
Cost reduction in material waste	$8,300.00
Additional annual cost of maintenance	-$57,600.00
Total net annual cost saving promised by welding machine	$72,700.00

Solution 2a:

Computation of NPV - Replacement proposal of Welding Machine - Superior Equipment Company
Particulars	Period	Amount	PV Factor	Present Value
Cash Outflows:
Cost of Welding machine	0	$340,000.00	1	$340,000.00
software and installation cost	0	$92,000.00	1	$92,000.00
Sale value of old equipment	0	-$21,000.00	1	-$21,000.00
Replacement cost of worn out parts	3	$55,000.00	0.69305	$38,117.76
Present value of cash outflows (A)				$449,117.76
Cash Inflows:
Annual net cost savings	1-6	$72,700.00	3.99755	$290,621.87
Salvage value of new machine	6	$38,000.00	0.48032	$18,252.10
Present value of cash Inflows (B)				$308,873.97
NPV (B-A)				-$140,243.79

Solution 2b:

As NPV of replacement proposal is negative, therefore it is not recommended to purchase automated welding machine.

Solution 3:

Minimum dollar value per year attach to intangible benefits in order to make new welding machine as an acceptable investment = Differnce in present value of cash outflows and PV of cash inflows / Cumulative PV factor for 6 years at 13%

= $140,243.79 / 3.99755 = $35,082.44