Question

The WRL Company operates a snack-food center at the Grantley Adams Airport. On January 2, 2003, WRL purchased a special cookie cutting machine, which has been used for 3 years. WRL is considering purchasing a newer, more efficient machine. If purchased, the new machine would be acquired today on January 2, 2006. WRL expects to sell 300,000 cookies in each of the next 4 years. The selling price of each cookie is expected to average $0.50.

WRL has two options: (1) continue to operate the old machine, or (2) sell the old machine and purchase the new machine. The seller of the new machine offered no trade in. The following information has been assembled to help management decide which option is more desirable.

	Old Machine	New Machine
Initial machine investment	$80,000	$120,000
Terminal disposal price at end of useful life assumed for depreciation purposes	$10,000	$20,000
Useful life at date of acquisition	7 years	4 years
Expected annual cash operating costs
Variable cost per cookie	$0.20	$0.14
Total fixed costs	$15,000	$14,000
Depreciation method used for tax purposes	Straight-line	Straight-line
Estimated disposal prices of machines
January 2, 2006	$40,000	$120,000
December 31, 2009	$7,000	$20,000

WRL has a 40% income tax rate. Assume that any gain or loss on the sale of machinery is treated as an ordinary tax item and will affect the taxes paid by WRL in the year in which it occurs. WRL has an after tax required rate of return of 16%.

Required:

Use the present value method to determine whether WRL should retain the old machine or acquire the new machine.                                                                      [17 marks]

Assume that the financial differences between the net present value of the two options are so slight that WRL is indifferent between the two proposals. Identify and discuss the non-financial and qualitative factors that WRL should consider. [5 marks]

“Discounted cash-flow techniques are relevant only to profit seeking organizations.” Do you agree? Explain. [ 3 marks]

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Answer 1