Equipment replacement, relevant costs, sensitivity analysis. A toy manufacturer that spe¬

cializes in making fad items has just developed a $60,000 moulding machine for producing a special toy. The machine has been used to produce only one unit so far. The company will amortize the $60,000 initial machine investment evenly over four years, after which production of the toy will be stopped. The company’s expected annual costs will be direct materials, $12,000; direct manufacturing labour, $24,000; and variable manufacturing over¬

head, $18,000. Variable manufacturing overhead varies with direct manufacturing labour costs. Fixed manufacturing overhead, exclusive of amortization, is $9,000 annually, and fixed marketing and administrative costs are $14,400 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 $52,800 and will have a zero terminal disposal price at the end of four years.

Production and sales of 25,000 units per year (sales of $120,000) will be the same whether the company uses the old machine or the new machine. The current disposal price ofthe toy company’s moulding machine is $6,000. Its terminal disposal price in four years will be $3,120.

840 Required 1. Assume that the required rate of return is 16%. Using the net present value method, show whether the new machine should be purchased. What is the role ofthe book value ofthe old machine in the analysis?

2. What is the payback period for the new machine?

3. As the manager who developed the $60,000 old moulding machine, you are trying to justify not buying the new $52,800 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?