Question

Net Present Value Analysis; Uncertain Cash Flows

“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 $80,000 for software and installation, and another $3,000 every month just to maintain the thing. In addition, the manufacturer admits that it would cost $45,000 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 $108,000 per year. And we would save another $6,500 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 $12,000 scrap value out of our old welding equipment if we sell it now, and in 12 years the new machine will only be worth $20,000 for parts. But have your people work up the figures and we’ll talk about them at the executive committee meeting tomorrow.”

Required:

(Ignore income taxes.)

1. Compute the annual net cost savings promised by the automated welding machine.

2. Using the data from (1) above and other data from the problem, compute the automated welding machine’s net present value. (Use the incremental-cost approach.) Would you recommend purchasing the automated welding machine? Explain.

3. 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?

Answer 1

(1) The annual net cost savings would be:

Reduction in labor costs	$108,000
Reduction in material waste	$6,500
Total	$114,500
Less: increased maintenance costs ($3,00012)	($36,000)
Annual net cost savings	$ 78,500

(2) The net present value analysis would be:

Item	Year(s)	Amount of Cash Flows	16% Factor	Present Value of Cash Flows
Cost of the machine	Now	($500,000)	1.000	($500,000)
Software and installation	Now	($80,000)	1.000	($80,000)
Salvage of the old equipment	Now	$12,000	1.000	$12,000
Annual cost savings	1-12	$78,500	5.197	$407,965
Replacement of parts	7	($45,000)	0.354	($15,930)
Salvage of the new machine	12	$20,000	0.168	$3,360
Net present value				($172,605)

No, the automated welding machine should not be purchased. Its net present value is negative.

(3) The dollar value per year that would be required for the intangible benefits is:

Dollar value per year that would be required =

Dollar value per year that would be required = $33,212

Thus, the automated welding machine should be purchased if management believes that the intangible benefits are worth at least $33,212 per year.