\"I\'m not sure we should lay out $500,000 for that automated welding machine,\"
ID: 2375394 • Letter: #
Question
"I'm not sure we should lay out $500,000 for that automated welding machine," said Jim Alder, president of the Superior Equipment Company. "That's a lot of money, and it would cost us $86,000 for software and installation, and another $2,700 every month just to maintain the thing. In addition, the manufacturer admits that it would cost $44,000 more at the end of seven years to replace worn-out parts."
"I admit it's a lot of money," said Franci Rogers, the controller. "But you know the turnover problem we've had with the welding crew. This machine would replace six welders at a cost savings of $112,200 per year. And we would save another $7,500 per year in reduced material waste. When you figure that the automated welder would last for 12 years, I'm sure the return would be greater than our 16% required rate of return."
"I'm still not convinced," countered Mr. Alder. "We can only get $15,000 scrap value out of our old welding equipment if we sell it now, and in 12 years the new machine will only be worth $22,000 for parts. But have your people work up the figures and we'll talk about them at the executive committee meeting tomorrow." (Ignore income taxes.)
Annual net cost savings- $87,300
Using the data from requirement 1 above and other data from the problem, compute the automated welding machine's net present value. (Use the incremental-cost approach.)
Net present value $___________________
Assume that management can identify several intangible benefits associated with the automated welding machine, including greater flexibility in shifting from one type of product to another, improved quality of output, and faster delivery as a result of reduced throughput time. What dollar value per year would management have to attach to these intangible benefits in order to make the new welding machine an acceptable investment?
Intangible benefits- $______________ per year
"I'm not sure we should lay out $500,000 for that automated welding machine," said Jim Alder, president of the Superior Equipment Company. "That's a lot of money, and it would cost us $86,000 for software and installation, and another $2,700 every month just to maintain the thing. In addition, the manufacturer admits that it would cost $44,000 more at the end of seven years to replace worn-out parts."
Explanation / Answer
Upfront investment = 500,000+86000(for installation)-15000(scrap value of current machine) = 571,000
Additional annual costs = 2700*12=32,400
Cost savings per year = 112,200+7500=119,700
Additional one-time cost aftr 7 yrs = 44,000
Scrap value after 12 years = 22,000
So cashflows are:
Year 0: - 571,000
Year 1:119,700-32,400 = 87,300
Year 2:119,700-32,400 = 87,300
Year 3:119,700-32,400 = 87,300
Year 4:119,700-32,400 = 87,300
Year 5:119,700-32,400 = 87,300
Year 6:119,700-32,400 = 87,300
Year 7:119,700-32,400-44,000 (for replacing parts) = 43,300
Year 8:119,700-32,400 = 87,300
Year 9:119,700-32,400 = 87,300
Year 10:119,700-32,400 = 87,300
Year 11:119,700-32,400 = 87,300
Year 12:119,700-32,400+22,000 = 109,300
Discounting this at 16% IRR, we get NPV = -571,000+87,300/(1.16^1)+87,300/(1.16^2)+...+109,300/(1.16^12) = -$129,155
As this is negative, they should not purchase the new machine.
To make this acceptable investment, let dollar value of intangible be $X.
So X/(1.16^1)+X/(1.16^2)+X/(1.16^3)+...+X/(1.16^11)+X/(1.16^12) = 5.197X. This is equal to the NPV of 129,155, so X should be 129,155/5.197 = $24,851.3
Hope this helped. Let me know in case of queries.
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