Equipment Replacement and Strategic Considerations The management of Devine Instrument Company is considering the purchase of a new drilling machine, model RoboDril 1010K. Accord- ing to the specifications and testing results, RoboDril will substantially increase productivity over AccuDril X10, the machine Devine is currently using.
The AccuDril was acquired 8 years ago for $120,000 and is being depreciated over 10 years expected useful life with an estimated salvage value of $20,000. The engineering department expects the AccuDril to keep going for another three years after a major overhaul at the end of its expected useful life. The estimated cost for the overhaul is $100,000. The overhauled machine will be depreciated using straight-line depreciation with no salvage value. The overhaul will improve the machine's operating efficiency approximately 20 percent. No other operating conditions will be affected by the overhaul.
RoboDril 1010K is selling for $250,000. Installing, testing, rearranging, and training will cost another $30,000. The manufacturer is willing to take the AccuDril as a trade-in for $40,000. The RoboDril will be depreciated using the straight-line method with no salvage value. New technology most likely will make RoboDril obsolete to the firm in five years.
Variable operating cost for either machine is the same: $10 per hour. Other pertinent data follow:
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AccuDril X10
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RoboDril 1010K
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Units of output (per year)
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10,000
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10,000
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Machine-hours
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8,000
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4,000
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Selling price per unit
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$100
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$100
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Variable manufacturing cost (not including machine-hours)
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$40
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$40
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Other annual expenses (tooling and supervising)
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$95,000
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$55,000
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Disposal value-today
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$25,000
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Disposal value-in five years
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0
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$50,000
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Devine Instrument Company's weighted-average cost of capital (WACC) is 12 percent, and it is in the 40 percent tax bracket.
Required
1. Determine the effect on cash flow for items that differ for the two alternatives.
2. Compute the payback period for purchasing RoboDril 1010K rather than having AccuDril X10 over- hauled in two years.
3. What is the present value of each decision alternative?
4. What other factors, including strategic issues, should the firm consider before making the final decision?