Several years ago, Catherine’s Cattery Supplies signed a contract to deliver 5000 units of a special product each year to one of its customers at a price of $15 per unit. This contract, which runs for five more years, is non-cancellable.

Catherine is currently making the product with an old machine that can be kept running for five more years if $9000 of maintenance cost per year is incurred. Other operating costs to produce it with the old machine (excluding maintenance)

total $45 000 per year. The old machine has no residual value now, and will have none after the contract is fulfilled.

Pedro’s Pet Products recently offered to sell Catherine 5000 units of the product per year over the next five years for

$10.50 per unit. Catherine had almost decided to accept the offer from Pedro as the best possible way to satisfy its contract, when a new machine capable of producing the 5000 units each year for $42 000 total cash operating costs per year became available. This new machine would cost $41 250 and would have a residual value of $7500 after five years.

Catherine’s required rate of return is 16 per cent.

Required:

a Is purchasing 5000 units of the product per year from Pedro’s Pet Products preferable to producing them with the old machine? Explain.

b By calculating its NPV, determine the acceptability of the proposed capital expenditure to buy the new machine.

c If Pedro’s Pet Products withdrew its offer to supply the units, would your answer to

(b) change? Explain, supporting your explanation with calculations if necessary.