NPV Analysis

Kingsley 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 of the 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 fi rst used in production. The scrap value of both machines is negligible and can be ignored. Straight-line depreciation is used.

b. The cost of a new model 800 machine is $300,000.

c. The model 400 machine now in use cost $160,000 three years ago. Its present book value is
$112,000, and 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:

Production
Year 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
Direct materials per unit. . . . . . . . . . . $0.25 $0.40
Direct labor per unit . . . . . . . . . . . . . . 0.49 0.16
Supplies and lubricants per unit . . . . 0.06 0.04
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:
(Ignore income taxes.)

1. Which alternative should the company choose? Use the net present value approach

2. Suppose that the cost of direct labor increases by 10%. Would this make the model 800 machine more or less desirable? Explain. No computations are needed.

3. Suppose that the cost of direct materials doubles. Would this make the model 800 machine more or less desirable? Explain. No computations are needed.