NPV and payback calculation plus a replacement decision The management of a hotel group is deciding whether to scrap an old but still serviceable machine bought five years ago to produce fruit pies and replace it with a newer type of machine.

It is expected that the demand for the fruit pies will loast for a further five years only and will be as follows:

The fruit pies are currently sold for £3 per pie.
Each machine is capable of meeting these requirements.
Data for the two machines are as follows:

Unit operating costs, fixed overhead costs and selling price are expected to remain constant throughout the five-year period.
Required:

(a) Using data relating only to the new machine:
(i) calculate the payback period of the new machine;
(ii) calculate the net present value of the new machine.
Note: The hotel group expects that its cost of capital will be 20% p.a. throughout the period. (10 marks)

(b) Assume that the existing machinery could be sold for £130000 immediately, if it were replaced. Show, using present value calculations, whether the existing machine should be replaced by the new machine. (8 marks)

(c) Assume that no new machinery can be purchased, but that an outside caterer has offered to supply all of the hotel group’s requirements for fruit pies at a price which compares favourably with the group’s own cost of producing the pies.
What factors other than price would need to be considered before making a decision whether to accept the offer. (7 marks)
(Total 25 marks)
AAT

Transcribed Image Text:

Produced and sold number of pies Year 1 40 000 Year 2 40 000 Year 3 30 000 Year 4 20 000 Year 5 20 000