Due to the increasing energy costs in the US, Jackie Moora is anxious. The old machine her company has been using to manufacture steel support beams for the construction industry is 5 years old, and it served the company well over the past 5 years. Jackie expected the machine to last another 7 years. At which point she would have to replace the machine with another one. The existing machine was purchased for $3 million ($3M) and is expected to have no resale value at the end of its life or-for that matter-if it were to be sold at present. The machine is depreciated straight-line for 10 years, so has another 5 years of depreciation left. Jackie is concerned that higher cost of energy may reduce the profitability of their operations when utilizing the existing machine, and is considering whether buying a new machine now-that is, replacing the existing machine at present rather than waiting another 7 years-makes financial sense. Or whether continuing production makes sense at all. For the most recent fiscal year, sales have been 2M per year, and all costs pre-tax are 1.4M per year. Of these costs, direct labor associated with the existing machine is $300,000, energy costs are 600,000, and depreciation is 300,000 (expected for another 5 years). $200,000 are administrative costs, mainly administrative salaries. While sales and salaries are expected to increase at the rate of inflation of 5% per year for the foreseeable future, energy costs outpace inflation and are expected to grow at 20% in the future starting now. Demand for the support beams is quite elastic due to competition from foreign producers, meaning that the company cannot raise prices for their products above and beyond the 5% inflation rate. As an alternative, Jackie Moora is looking for another option. She is considering whether it would be better to buy a wholly new machine. The current price is 4.5M, but the machine would have the effect of dropping energy costs to 200,000 for the next year. These costs, again, would grow at the 20% energy growth rate in the future. The new machine would be expected to last 10 years, depreciated straight-line over that period, and have no resale value at the end of that period.
Due to the increasing energy costs in the US, Jackie Moora is anxious. The old machine her company has been using to manufacture steel support beams for the construction industry is 5 years old, and it served the company well over the past 5 years. Jackie expected the machine to last another 7 years. At which point she would have to replace the machine with another one. The existing machine was purchased for $3 million ($3M) and is expected to have no resale value at the end of its life or-for that matter-if it were to be sold at present. The machine is depreciated straight-line for 10 years, so has another 5 years of depreciation left. Jackie is concerned that higher cost of energy may reduce the profitability of their operations when utilizing the existing machine, and is considering whether buying a new machine now-that is, replacing the existing machine at present rather than waiting another 7 years-makes financial sense. Or whether continuing production makes sense at all. For the most recent fiscal year, sales have been 2M per year, and all costs pre-tax are 1.4M per year. Of these costs, direct labor associated with the existing machine is $300,000, energy costs are 600,000, and depreciation is 300,000 (expected for another 5 years). $200,000 are administrative costs, mainly administrative salaries. While sales and salaries are expected to increase at the rate of inflation of 5% per year for the foreseeable future, energy costs outpace inflation and are expected to grow at 20% in the future starting now. Demand for the support beams is quite elastic due to competition from foreign producers, meaning that the company cannot raise prices for their products above and beyond the 5% inflation rate. As an alternative, Jackie Moora is looking for another option. She is considering whether it would be better to buy a wholly new machine. The current price is 4.5M, but the machine would have the effect of dropping energy costs to 200,000 for the next year. These costs, again, would grow at the 20% energy growth rate in the future. The new machine would be expected to last 10 years, depreciated straight-line over that period, and have no resale value at the end of that period.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:Moora Inc.
Due to the increasing energy costs in the US, Jackie Moora is anxious. The old machine her
company has been using to manufacture steel support beams for the construction industry is 5
years old, and it served the company well over the past 5 years. Jackie expected the machine to
last another 7 years. At which point she would have to replace the machine with another one. The
existing machine was purchased for $3 million ($3M) and is expected to have no resale value at
the end of its life or-for that matter-if it were to be sold at present. The machine is depreciated
straight-line for 10 years, so has another 5 years of depreciation left.
Jackie is concerned that higher cost of energy may reduce the profitability of their operations
when utilizing the existing machine, and is considering whether buying a new machine now-that
is, replacing the existing machine at present rather than waiting another 7 years-makes financial
sense. Or whether continuing production makes sense at all.
For the most recent fiscal year, sales have been 2M per year, and all costs pre-tax are 1.4M per
year. Of these costs, direct labor associated with the existing machine is $300,000, energy costs
are 600,000, and depreciation is 300,000 (expected for another 5 years). $200,000 are
administrative costs, mainly administrative salaries.
While sales and salaries are expected to increase at the rate of inflation of 5% per year for the
foreseeable future, energy costs outpace inflation and are expected to grow at 20% in the future
starting now. Demand for the support beams is quite elastic due to competition from foreign
producers, meaning that the company cannot raise prices for their products above and beyond
the 5% inflation rate.
As an alternative, Jackie Moora is looking for another option. She is considering whether it would
be better to buy a wholly new machine. The current price is 4.5M, but the machine would have
the effect of dropping energy costs to 200,000 for the next year. These costs, again, would grow
at the 20% energy growth rate in the future. The new machine would be expected to last 10 years,
depreciated straight-line over that period, and have no resale value at the end of that period.
Transcribed Image Text:Tax rate is 25% and since this is a small enterprise with a lot of risk, discount rate used in 20% per
year.
Jackie and the team of directors are seeking your help with the analysis of all possible scenarios.
1) What should the company do? Should the company stay in business or shut down operations?
2) If they should stay in business, should they keep the old machine, or buy the new one?
Jackie and the team of directors encourage you to think carefully about how to approach the
analysis. They need the decisions to be backed by present value analysis and numbers. All possible
scenarios of operations need to be considered.
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