Company ABC has developed a new product for which a growing demand is anticipated.

Company ABC need to choose between 2 alternative production arrangements:

(a) Buy a large machine with a capacity of 90,000 units and an estimated useful life of 6 years. The machine costs $250,000 payable now.

(b) Buy a smaller machine with a capacity of 50,000 units and an estimated useful life of 3 years. Three years from today buy 2 such machines to replace the one that will be worn out. The small machines now cost $100,000 each.

Other details:Insurance premium per year are expected to be $8,000 on the large machine and 4% of original cost of equipment in use on the small machines. Maintenance cost is expected to be $2,000 per year on the large machine and $1,200 per year on the small machines. Variable production costs per unit will be $3.00 with the large machine and $3.10 with the small machine.Both large and small machines will have zero disposal values at the end of their respective useful lies.Prices on the small machines have been increasing at the rate of 4% compounded annually.Notes:-

• Present values Table of $1 at 10% are:

• $1 compounded at 4% after 3 years equal $1.125

Required:

Assuming a cost of capital of 10% compute:(a) The net present value of the large machine;(b) The net present value of the small machine and(c) State briefly which machine you would prefer.

Solution:Large Machine Small Machine

© Between the two types of machinery, Company ABC should choose to buy the large machine as they represent a lower net cash outflow in terms of present valueWorkings:Large Machine

Small machine:-

 Other workings:

(1) Production units x ($3.00-$3.10)

(2) Note 4: 2 machines, $200,000 x compound value 1.125=$225,000

(3) After year 3, insurance=4% x$225,000

(4) After year 4, maintenance on 2 machines

If you found this post useful, keep updated with future posts by subscribing to FMAccounting (for free) through RSS or email.

Related Entries

• Test Question Bank
• Main Content Page For Articles On Investment Management
• Investment Appraisal: Time Value And Present Value Of Money
• Net Present Value As The Most Superior Method
• Checklist On Types Of Waste Activities In An Organization