A company that manufactures toys has just developed a $50,000 molding machine for producing a special toy. The machine has not been used yet and depreciation on the machine will be on a straight-line basis over four years, with a $2,600 expected salvage value. The company's expected annual costs will include direct materials, $10,000; direct labor, $20,000; and variable overhead of $15,000. Variable overhead varies with direct labor costs. Fixed manufacturing overhead, exclusive of depreciation, is $7,500 annually, and fixed marketing and administrative costs are $12,000 annually.
A salesperson has just visited the company with a new machine that is ideally suited for producing this toy. This machine is highly automated and is distinctively superior to the internally developed machine. It would reduce the cost of direct materials by 10% and it would produce twice as many units per hour. It would cost $44,000 and it would have no salvage value at the end of its 4 year life.
The company sells the toys for $4 each and it produces and sells 25,000 of them per year. The current disposal price of the company's molding machine is $5,000. Its terminal disposal price in 4 years would be $2,600.
1.Using a required rate of return of 18%, determine whether the new machine should be purchased or not.
2.As the manager who developed the $50,000 old machine, you are trying to justify not buying the new $44,000 machine. You question the accuracy of the expected cash operating savings. By how much must these cash savings fall before the point of indifference (i.e., the point where the NPV of investing in the new machine is zero).