Equipment Replacement, Sensitivity Analysis A toy manufacturer who specializes in making fad items has just developed a $50,000 molding machine for automatically producing a special toy. The machine has been used to produce only one unit so far. It is planned to depreciate the $50,000 original cost evenly over four years, after which time production of the toy will be stopped.

Suddenly a machine salesman 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 materials by 10 percent and produces twice as many units per hour. It will cost $44,000 and will have zero disposal value at the end of four years.

Production and sales would continue to be at a rate of 25,000 per year for four years; annual sales will be $90,000. The scrap value of the toy com- pany’s machine is now $5,000 and will be $2,600 four years from now. Both machines will be useless after the 100,000-unit total market potential is exhausted.

With its present equipment, the company’s annual expenses will be: direct materials, $10,000; direct labor, $20,000; and variable factory overhead, $15,000. Fixed factory overhead, exclusive of depreciation, is $7,500 annually, and fixed selling and administrative expenses are $12,000 annually.

7. Assume that the hurdle rate of return is 18 percent. Using discounted cash- flow techniques, show whether the new equipment should be purchased. Use a total-project approach and an incremental approach. What is the role of the book value of the old equipment in the analysis?
2. What is the payback period for the new equipment?
3. As the manager who developed the $50,000 molding 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 net present value of the project is zero, is reached?  L01