Question

Please be detailed in your explanation and or excel work.

Metallic Peripherals, Inc. has received a production contract for a new product. The contract lasts for 5 years. To do the necessary machining operations, the firm can use one of its own lathes, which was purchased 3 years ago at a cost of $16,000. Today the lathe can be sold for $8,000. In 5 years the lathe will have a zero salvage value. Annual operating and maintenance costs for the lathe are $4,000/year. If the firm uses its own lathe it must also purchase an additional lathe at a cost of $12,000, its value in 5 years will be $3,000. The new lathe will have annual operating and maintenance costs of $3,500/year. As an alternative, the presently owned lathe can be traded in for $10,000 and a new lathe of larger capacity purchased for a cost of $24,000; its value in 5 years is estimated to be $8,000, and its annual operating and maintenance costs will be $6,000/year. An additional alternative is to sell the presently owned lathe and subcontract the work to another firm. Company X has agreed to do the work for the 5-year period at an annual cost of $12,000/end-of-year. Using a 15% interest rate, determine the least-cost alternative for performing the required production operations. a. Use the cash flow approach. b. Use the opportunity cost approach

Answer 1

a. Option 1 - Use of its own lathe
Year		Inflow / (Outflow)	Discounting rate @ 15%	Present value of inflow / (outflow)
		$		$
0	Purchase of new lathe	-12000	1	-12000
1	Operating and maintainance cost	-7500	0.87	-6525
2	Operating and maintainance cost	-7500	0.756	-5670
3	Operating and maintainance cost	-7500	0.658	-4935
4	Operating and maintainance cost	-7500	0.572	-4290
5	Operating and maintainance cost	-7500	0.497	-3728
5	Salvage value of new lathe	3000	0.497	1491
	Present value of cost			-35657
b. Option 2 - Buy new Lathe
Year		Inflow / (Outflow)	Discounting rate @ 15%	Present value of inflow / (outflow)
		$		$
0	Sale of old Lathe	10000	1	10000
0	Purchase of new Lathe	-24000	1	-24000
1	Operating and maintainance cost	-6000	0.87	-5220
2	Operating and maintainance cost	-6000	0.756	-4536
3	Operating and maintainance cost	-6000	0.658	-3948
4	Operating and maintainance cost	-6000	0.572	-3432
5	Operating and maintainance cost	-6000	0.497	-2982
5	Salvage value of new lathe	8000	0.497	3976
	Present value of cost			-30142
b. Option 3 - Subcontracting
Year		Inflow / (Outflow)	Discounting rate @ 15%	Present value of inflow / (outflow)
		$		$
0	Sale of old Lathe	8000	1	8000
1	Annual cost	-12000	0.87	-10440
2		-12000	0.756	-9072
3		-12000	0.658	-7896
4		-12000	0.572	-6864
5		-12000	0.497	-5964
	Present value of cost			-32236
	So by using cash flow and alternative cost approach, if Metallic Peripherels goes for option 2 its cost will be lower than option 1 and option 3
	So company should go for option 2