A company manufactures snowsuits. This company is considering purchasing a new s
ID: 2343784 • Letter: A
Question
A company manufactures snowsuits. This company is considering purchasing a new sewing machine at a cost of $2.5 million. Its existing sewing machine was purchased 5 years ago at a price of $1.8 million. Six months ago, the company spent $55,000 to keep it operational. The existing sewing machine can be sold today for $260,000. The new sewing machine would require a one-time $85,000 training cost. Operating costs would decrease by the following amounts from year 1 to 7:Year 1: $390,000
Year 2: $400,000
Year 3: $411,000
Year 4: $426,000
Year 5: $434,000
Year 6: $435,000
Year 7: $436,000
The new sewing machine would be depreciated according to the declining-balance method at a rate of 20%. The salvage value is expected to be $380,000. This new equipment would require maintenance costs of $95,000 at the end of the fifth year. The cost of capital is 9%.
Use the net present value method to determine if the company should purchase the new machine to replace the existing machine and state the reason for your conclusion.
Explanation / Answer
To answer the question, we need to compare cash-out flow to discounted cash flow from the purchase of the new machine in year 0(present)
1) Cash-out flow in year 0
2,500,000(new machine)+85,000(training)-260,000(old machine)=2,325,000
2) Discounted cash flow in year 0
To find the discounted cash flow, we discount each year net cash flow by using the per year rate of 9%. The rate should be compounded. I assumed that the new machine will be sold in year 7.
year 1 390,000/1.09 = 357,798.17
year 2 400,000/(1.09)^2 = 336,672.00
year 3 411,000/(1.09)^3 = 317,367.41
year 4 426,000/(1.09)^4 = 301,789.14
year 5 (434,000-95,000(maintenance))/(1.09)^5 = 220,326.74
year 6 435,000/(1.09)^6 = 259,376.29
year 7 (436,000 + 380,000(residual value of the new machine))/(1.09)^7 = 446,379.94
Total 2,239,709.69
Since the cash-out flow(2,325,000) is larger than the discounted cash flow(2,239,709.69), we conclude that we shouldn't buy the new machine. The cost of buying the new machine exceeds the benefit since buying the new machine does not create positive net cash flow.
By the way, the cost of the old machine and the money spent on the old machine are not relevant in deciding whether the new machine should be bought or not because these costs are sunk costs.
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