Question

The Plant department of the local telephone company purchased four special pole hole diggers eight years ago for $14,000 each. They have been in constant use to the present time. Due to an increased workload, it is considered that additional machines will soon be required. Recently it was announced that an improved model of the digger has been put on the market. The new machines have higher production rate and lower maintenance expense than the old machines, but their cost will be $32,000 each. The service life of the new machines is estimated to be 8 years with salvage estimated at $750 each. the four original diggers have an immediate salvage of $2,000 each and an estimated salvage of $500 each eight years hence. The estimated average annual maintenance expense associated with the old machines is approximately $1,500 each compared to $600 each for the new machines. A field study and trial indicates that the workload would require three additional new type machines if the old machines are continued in service. However, if the old machines are all retired from service, the present workload plus the estimated increased load could be carried by 6 new machines with an annual savings of $12,000 in operator costs. Because the new machines employ a new principle of operation, it is contrmplated that the special personnel-training program will be necessary before the machines can be placed in operation it is estimated that this training program will cost about $700 per new machine. if the MARR is 9% before taxes, what should the company do?

A) 6 new machines because they save/ cost $X per year. (find this amount X)

B)3 new machines and 4 old machines because they save/cost $X per year. (find this amount X)

C)Collect more information because with the given information, this problem cannot be solved.

Answer 1

In the above said question, the comparison will be made will respect to the costs incurred and the costs saved. The cost incurred will be a cash outflow for the company and the costs saved will be inflow of cash for the company. The Cash flows will be discounted to their Present Value. As per the data provided, I have listed out the following with respect to the options mentioned above.

Situation A)

Here, the company will be saving the following costs with respect to the old machinery:

1. Annual Maintenance Expenses (@ $1500 * 4 = $6,000 per year)

2. Operator Cost ($12,000 per year)

Here, the only Cash inflow that will happen (in respect of old machines) will be the salvage value i.e. $2,000 * 4 = $ 8,000.

Further, the company will be incurring the following costs with respect to the new machinery:

1. Machine Purchase Cost (@ $32000 * 6 = $192,000)

2. Initial Training Program Cost (@ $700 * 6 = $ 4,200)

3. Annual Maintenance Cost (@ $600 * 6 = $ 3,600)

Further, after 8 years, there will be the salvage proceeds of the new machines that will be cash positive for the company @ $750 * 6 = $4,500

We now calculate the cash flows for the next 8 years and discount them to their Present Value at the rate of 9 % i.e. MARR in this case:

Year	Cost of New Machinery	Initial Training Program cost of new machine	Proceeds from Sale of Old machinery / Salvage Value	Annual Saving	AMC cost saved wrt Old Machiner	AMC cost for new machinery	Net cash flows	Present Value Factor @ 9%	Present Value of Cash Flows
0	-1,92000	-4,200	8,000	0	0	0	-187,600	1	-188,200
1	0	0	0	12,000	6,000	-3,600	14,400	0.917	13,204.8
2	0	0	0	12,000	6,000	-3,600	14,400	0.842	12,124.8
3	0	0	0	12,000	6,000	-3,600	14,400	0.772	11,116.8
4	0	0	0	12,000	6,000	-3,600	14,400	0.708	10,195.2
5	0	0	0	12,000	6,000	-3,600	14,400	0.65	9,360.0
6	0	0	0	12,000	6,000	-3,600	14,400	0.596	8,582.4
7	0	0	0	12,000	6,000	-3,600	14,400	0.547	7,876.8
8	0	0	4,500	12,000	6,000	-3,600	18,900	0.502	9,487.8
								Net Cash flows	-106,251

Hence, we see that there will be initial cash outflow of $188,200 for the new machinery. In the next 8 years, the company will have cash inflows. After discounting them to their Present Value, it can be seen that the net cash outflow will be $106,251. That means the company will be expending $13,281.37 per year (i.e. $106,251 / 8 years).

Situation B)

In this situation, to manage the workload, 3 new machines will be purchased and the four old machines will continue in operation.

The Expenses incurred with regard to the new machinery will be as follows:

1. Cost of Purchase (@ $32,000 * 3 = $96,000)

2. Training Program Cost (@ $700 * 3 = $2,100)

3. Annual Maintenance Cost (@ $600 * 3 = $1800 per year)

In the 8th year, there will be cash inflow of the salvage value from sale i.e. $500* 4 (for old) + $ 750* 3 (for new) = $4,250.

We now calculate the cash flows for the next 8 years and discount them to their Present Value at the rate of 9 % i.e. MARR in this case:

Year	Cost of New Machinery	Training Program cost of new machine	Salvage Value	AMC cost incurred for new machine	Net cash flows	Present Value Factor @ 9%	Present Value of Cash Flows
0	-96,000	-1,800	0	0	-97,800	1	-97,800
1	0	0	0	-1,800	-1,800	0.917	-1,650.6
2	0	0	0	-1,800	-1,800	0.842	-1,515.6
3	0	0	0	-1,800	-1,800	0.772	-1,389.6
4	0	0	0	-1,800	-1,800	0.708	-1,274.4
5	0	0	0	-1,800	-1,800	0.65	-1,170.0
6	0	0	0	-1,800	-1,800	0.596	-1,072.8
7	0	0	0	-1,800	-1,800	0.547	-984.6
8	0	0	4,250	-1,800	2,450	0.502	1,229.9
						Net Cash Flows	-105,628

In this situation, we can observe that, except for the 8th year, the company will be having cash outflows for the coming years. The net cash outflow will be $105,628. Hence, the company will be expending $13,203.5 per year (i.e. $105,628 / 8 years).

Conclusion:

After comparing both the situations, it can be observed that the company will be better off if they decide to purchase 3 new machines and keep the old machines in working, since it would cost less. Hence, the company should decide on Situation B).