Question

Q3.

The management at Big Toy Company is considering purchasing a new machine and it has gathered the following data:

A) The cash needed to buy the new machine is $65,000
b) The residual value and operating expenses for the next five years are:

Year	Residual Value at year end	Annual cash operating expenses
1	50 000	12 000
2	40 000	14 000
3	30 000	18 000
4	24 000	23 000
5	5 000	28 000

C) The required rate of return is 13% per year
D) The effects of company tax can be ignored.

What is the optimum replacement policy for this machine? Show your workings.

Answer 1

Year	Annual operating expenses	PVIF for 13%	PV of annual operating expenses = Annual operating expenses*PVIF	Cumulative PV of operating costs	Depreciation = Book value - residual value	Total cost = cumulative PV of operating costs+Depreciation	Cumulative PV factors	Weighted average cost = Total cost/cumulative PV factors
1	12,000.00	0.88496	10,619.47	10,619.47	15,000.00	25,619.47	0.88496
2	14,000.00	0.78315	10,964.05	21,583.52	10,000.00	31,583.52	1.66810	18,933.80
3	18,000.00	0.69305	12,474.90	34,058.43	10,000.00	44,058.43	2.36115	18,659.71
4	23,000.00	0.61332	14,106.33	48,164.76	6,000.00	54,164.76	2.97447	18,209.88
5	28,000.00	0.54276	15,197.28	63,362.03	19,000.00	82,362.03	3.51723	23,416.72

Thus the weighted average cost is least in the 4th year and so the machine should be replaced in the 4th year