You have opened your own word processing service.You have already bought a speci

Question

You have opened your own word processing service.You have already bought a special computer needed for word processing and paid $5000 for it. However, due to the cost changes in the computer, industry, the current price of an equivalent machine is $2500. You could sell any used machine for 200 dollars - and no machine can be used for more than one year. If you were not word processing, you could earn $20,000 per year at an alternative job. Assume that the interest rate is 10%.

You can also hire an assistant who can do everything that you would do for $20,000 per year, and you would still continue to do word processing. One person using one computer can produce 11,000 typed pages per year, and the price per page for your service is $2.

Calculate the following three options:

You are considering three options: (1) leave your business the way it is, (2) expand your business by hiring an assistant, or (3) shut down all operations.

Based on the costs and revenues above, which should you do? Explain and show any relevant calculations.

Explanation / Answer

The question does not give one important information required for compelete satisfaction in solving it: the life of the wordprocessor computer..
However, we can still solve it. We have three options and their benefits and costs as folows:
Item..Shtdwn..StatusQo.Expand
Capital
Investment.0.....1000....3500....
--------------------------------------…
Income from
word-
processing..0...22000..44000...
Income by
mahine sell..1000....0......0.......
Income from
Alternative
job..........20000....0...... 0 .....
--------------------------------------…
Total
Income..21000..22000..44000...
--------------------------------------…
Expenditure
Interest on
Investment ...0....100.......350....
Assistant's
Remuneration..0....0....20000....
--------------------------------------…
Expenditure....0.....0...20350..
--------------------------------------…
Net
Income..21000..21900...23750....
Thus, from the above calculations, continuing to do self-employed word processing or shut-down options are worse than business expansion option,without taking into account capital investment of $1000 for status quo (forgoing 1000 that could have been realized by selling the machine) and $3500 capital investment (1000+2500) under expansion option.
If a single period is considered to recoup the capital, then however, Status quo option will be the best as it would have the highest net cashflow as cmputed below:
Shut down: 21000
Status uo: 21900+100(interest)+1000(sale of computer)= 23000
Expand: 23750+350(interest) +2000(sale of two computers after one year)= 26000
My calculations above are just illustrative of how one goes about doing these kinds of sums. Uf you want you can reformulate to find out the prsent values by discounting cashflows at 10%.
For shut down the Prsent Value remains the same at $21000. For Status Quo it would be -1000 + 23000/1.1 and for the expansion option the NPV would be - 3500 + 26000/1.1.If you comput these you will find that the Expansion option is still the best.
You may be wondering that I have not taken the investment of $5000 for the first computer but taken it as $1000. The reason is that past sunk costs are not relevant . The old computer is valued at $1000 at the time the decisions are being taken.

change the values

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