K&G Company currently sells 1 million units per year of a product to one customer at a price of $3.80 per unit. The customer requires that the product be exclusive and expects no increase in sales during the five-year contract. The company manufactures the product with a machine that it purchased seven years ago at a cost of $700,000. Currently, the machine has a book value of $450,000 but the market value is only $230,000. The machine is expected to last another five years, after which it will have no salvage value. Last year, the production variable costs per unit were as follows:
Direct materials......................$1.20
Direct labour...........................0.70
Variable overhead.....................0.50
Total variable cost per unit.........$2.40
The company president is considering replacing the old machine with a new one that would cost $800,000. The new machine is expected to last five years. At the end of that period, the salvage value will be $350,000. The president expects to save 5% of the company's total variable costs with the new machine.
Instructions
Assume that the company's desired rate of return is 12%. Using the net present value method, determine if the company should replace the old machine with the new one, and briefly explain why or why not. Show your calculations.