Equipment r epla c ement, r e l ev ant c o s ts, sensitivity ana l ysis. A toy manufacturer that 1 answer below »

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Equipment r epla c ement, r e l ev ant c o s ts, sensitivity ana l ysis.

A toy manufacturer that specialises in making fad items has just developed a £50 000 mould- ing machine for producing a special toy. The machine has been used to produce only one unit so far. The company will depreciate the £50 000 initial machine investment evenly over fours years, after which production of the toy will be stopped. The company’s expected annual costs will be direct materials, £10 000; direct manufacturing labour, £20 000; and variable manufacturing overhead, £15 000. Variable manufacturing overhead varies with direct manufacturing labour costs. Fixed manufacturing overhead, exclusive of depreciation, is £7500 annually, and fixed marketing and administrative costs are £12 000 annually.

Suddenly a machine salesperson appears. He has a new machine that is ideally suited for producing this toy. His automatic machine is distinctly superior. It reduces the cost of direct materials by 10% and produces twice as many units per hour. It will cost £44 000 and will have a zero terminal disposal value at the end of four years.

Production and sales of 25 000 units per year (sales of £100 000) will be the same whether the company uses the old machine or the new machine. The current disposal value of the toy company’s moulding machine is £5000. Its terminal disposal value in four years will be £2600.

Required

1 Assume that the required rate of return is 18%. Using the net present-value method, show whether the new machine should be purchased. What is the role of the book value of the old machine in the analysis?

2 What is the payback period for the new machine?

3 As the manager who developed the £50 000 old moulding 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 – the point where the net present value of investing in the new machine – reaches zero?

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