Johan Products, Ltd., is using a model 400 shaping machine to make one of its products. The company is expecting to have a large increase in demand for the product and is anxious to expand its productive capacity. Two possibilities are under consideration:
Alternative 1. Purchase another model 400 shaping machine to operate along with the currently owned model 400 machine.
Alternative 2.Purchase a model 800 shaping machine and use the currently owned model 400 machine as standby equipment. The model 800 machine is a high-speed unit with double the capacity model 400 machine.
The following additional information is available on the two alternatives:
a. Both the model 400 machine and the model 800 machine have a 10-year life from the time they are first used in production. The scrap value of both machines is estimated at 20% of its original price.
b. The cost of new model 800machine is $300,000.
c. The model 400 machine now in use cost $160,000 three years ago. Its present market value is $90,000.
d. A new model 400 machine costs $170,000 now. If the company decides not to buy the model 800 machine, then the old model 400 machine will have to be replaced in seven years at a cost of $200,000. The replacement machine will be sold at the end of the tenth year for $140,000.
e. Production over the next 10 years is expected to be:
|
Year
|
Production in Units
|
|
1....................................
|
40,000
|
|
2...................................
|
60,000
|
|
3...................................
|
80,000
|
|
4-10.............................
|
90,000
|
f. The two models of machines are not equally efficient. Comparative variable costs per unit are:
|
|
Model
|
|
|
400
|
800
|
|
Total variable cost per unit............
|
$0.80
|
$0.60
|
g. The model 400 machine is less costly to maintain than the model 800 machine. Annual repairs and maintenance costs on a model 400 machine are $2,500.
h. Repairs and maintenance costs on a model 800 machine, with a model 400 machine used as standby, would total $3,800 per year.
i. No other costs will change as a result of the decision between the two machines.
j. Kingsley Products has a 20% required rate of return on all investments.
Required:
1. Compute the net cash flow for each alternative.
2. Draw the cash flow diagram for each alternative.
3. Which alternative should the company choose based on the PW and AW analysis?
4. What should the price of the product be under each alternative to make the AW equal to 0.
5. Suppose that the cost of variable cost doubles. Would this make the model 800 machine more or less desirable? Explain. No computations are needed.