Shellhammer Company is considering the purchase of a new machine. The invoice price of the machine is $170,000, freight charges are estimated to be $4,000, and installation costs are expected to be $6,000. Salvage value of the new equipment is expected to be zero after a useful life of 4 years. Existing equipment could be retained and used for an additional 4 years if the new machine is not purchased. At that time, the salvage value of the equipment would be zero. If the new machine is purchased now, the existing machine would be scrapped. Shellhammer’s accountant, Tracy Greene, has accumulated the following data regarding annual sales and expenses with and without the new machine.
1. Without the new machine, Shellhammer can sell 10,000 units of product annually at a per unit selling price of $100. If the new unit is purchased, the number of units produced and sold would increase by 20%. The selling price would remain the same.
2. The new machine is faster than the old machine, and it is more efficient in its usage of materials. With the old machine, the gross profit rate will be 25% of sales. With the new machine, the rate will be 28% of sales.
3. Annual selling expenses are $135,000 with the current equipment. Because the new equipment would produce a greater number of units to be sold, annual selling expenses are expected to increase by 10% if it is purchased.
4. Annual administrative expenses are expected to be $100,000 with the old machine and $113,000 with the new machine.
5. The current book value of the existing machine is $36,000. Shellhammer uses straight-line depreciation.
6. Shellhammer’s management wants a minimum rate of return of 15% on its investment and a payback period of no more than 3 years.
Instructions
With the class divided into groups, answer the following. (Ignore income tax effects.)
(a) Prepare an incremental analysis for the 4 years showing whether Shellhammer should keep the existing machine or buy the new machine.
(b) Calculate the annual rate of return for the new machine. (Round to two decimals.)
(c) Compute the payback period for the new machine. (Round to two decimals.)
(d) Compute the net present value of the new machine. (Round to the nearest dollar.)
(e) On the basis of the foregoing data, would you recommend that Shellhammer buy the machine? Why?
