The annual sales of a new product are projected to be 25,000 the first year and

Question

The annual sales of a new product are projected to be 25,000 the first year and increase by 10,000 per year until 55,000 are sold during the fourth year. Sales are then predicted to decrease by 5,000 per year in the fifth year and each year thereafter until 25,000 are sold in the tenth year.

- Proposal A is to purchase manufacturing equipment costing $120,000 with an estimated salvage value of $20000 at the end of 10 years.

- Proposal B is to purchase manufacturing equipment costing $280,000 with an estimated salvage value of $50,000 at the end of 10 years.

The variable manufacturing cost per unit under proposal A is estimated to be $0.80, but only $0.25 under proposal B.

a) If the interest rate is 9%, what is the Present Equivalent cost of each proposal for a 10-year production period?

b) Which proposal should be accepted for a 10-year production period?

Explanation / Answer

a)

b) As project A has a lower pesent equivalent cost, we should select project A.

Statement Calculating Present Equivalent Cost for Project A Heading / Time Period 0 1 2 3 4 5 6 7 8 9 10 Total Initial Cash Outlay at time 0 120000 Sales 25000 35000 45000 55000 50000 45000 40000 35000 30000 25000 Total Variable Cost (.8* Sales ) 20000 28000 36000 44000 40000 36000 32000 28000 24000 20000 Final Realised value at year 10 20000 Net Outflow(Initial Cash Outflow +Variable cost - Final Realised Value) 120000 20000 28000 36000 44000 40000 36000 32000 28000 24000 0 Discounting factor @ 9% 1 0.917431 0.84168 0.772183 0.708425 0.649931 0.596267 0.547034 0.501866 0.460428 0.422411 Present Value of the cost (Net Outflow * Discounting Factor) 120000 18348.62 23567.04 27798.61 31170.71 25997.26 21465.62 17505.1 14052.26 11050.27 0 310955.5 Statement Calculating Present Equivalent Cost for Project B Heading / Time Period 0 1 2 3 4 5 6 7 8 9 10 Total Initial Cash Outlay at time 0 280000 Sales 25000 35000 45000 55000 50000 45000 40000 35000 30000 25000 Total Variable Cost (.25* Sales ) 6250 8750 11250 13750 12500 11250 10000 8750 7500 6250 Final Realised value at year 10 50000 Net Outflow(Initial Cash Outflow +Variable cost - Final Realised Value) 280000 6250 8750 11250 13750 12500 11250 10000 8750 7500 -43750 Discounting factor @ 9% 1 0.917431 0.84168 0.772183 0.708425 0.649931 0.596267 0.547034 0.501866 0.460428 0.422411 Present Value of the cost (Net Outflow * Discounting Factor) 280000 5733.945 7364.7 8687.064 9740.847 8124.142 6708.007 5470.342 4391.33 3453.208 -18480.5 321193.1

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