Sife disposal co. the sife disposal company, a large manufacturer of f

The SIFE Disposal Company, a large manufacturer of first-quality garbage cans, has machine which produces garbage can lid handles. The financial manager for SIFE, Delbert Fritz (a recently graduated MBA), would like to know whether it would be more profitable to continue using the current machine or to purchase a new machine.
The Current garbage can lid handle producing machine, which was purchased last year, cost $20,000, had a 10-year life, and no expected salvage value. Because of the fantastic demand for these machines, SIFE could sell the machine for $18,000. Before selling it they would have to incur a $500 removal cost. Fixed company overhead costs are allocated on a basis of floor space occupied, so the current machine is assigned an overhead cost of $1,000 per year. Because the current machine reduced labor costs-compared to the old hand method- it was expected to produce a $5,000 annual cash savings over its remaining life. This savings was figured before the overhead cost was assigned. SIFE’s required rate of return is 10 percent. The company has a 50 percent tax rate and is currently using straight-line depreciation.
Delbert’s calculation of NPV for keeping the current machine appears in exhibit 1.
Exhibit 1

Amount for Years 2-10

Annual savings $5,000
Less annual overhead costs 1,000
Less depreciation 2,000
Income before tax 2,000
Tax 1,000
Income before tax $1,000
Plus depreciation 2,000
Net cash flow $3,000

Thus, NPV= -$18,000 + $3,000 (5.335) = $1,995

Delbert realizes that this negative NPV means he is not returning the required 10 percent on the $18,000 opportunity cost with the current machine and must now look for a new machine.
The Slippery Sanitation Equipment Corp. has offered to accept SIFE’s machine and $25,000 as the price of its new machine. This would enable SIFE to have Slippery’s new king-size garbage can lid handle machine which has an expected life of 9 years and a $9,000 salvage value. If the new machine is purchased, an installation cost of $1,500 and a removal cost for the current machine of $500 would be incurred .The financial manager, realizing that these costs would arise in any such transaction, has excluded them from his calculations. The new machine would result in a savings over the current machine of $7,500 in the first 4 years and $9,500 in years 5 through 9. This increased saving is the result of an additional reduction of labor costs. However the new machine, which is 50 percent large than SIFE’s current machine , takes up more floor space and will have an overhead cost allocation of $1,500 per year. Delbert feels that since the current machine is only 1 year old, he should use its original costs ($20,000) as the real trade-in value in determining the cost of the new machine. Thus:
New Machine Cost = $25,000 (cash) + $20,000 (trade-in) - $7,000 (salvage)= $38,000
Delbert’s calculation of NPV for purchasing the new machine appears in Exhibit 2.
Exhibit 2

Amount for Years 1-4 Amount for years 5-9

Annual savings $7,500 $9,500
Less annual overhead costs 1,500 1,500
Less depreciation 3,800 3,800
Income before tax 3,200 4,200
Tax 1,100 2,100
Income before tax $1,100 2,100
Plus depreciation 3,800 3,800
Net cash flow $4,900 $4,900

*depreciation = $38,000 (cost) / 10 years = $3,800 per year
Thus NPV = $4,900 (3.170) + $5,900 (6.144 – 3.170) - $38,000
= $15,000 + $17,546.60 - $38,000
= -$4,920.40
1. What did Delbert do incorrectly?
2. Find the errors in his analysis of the problem and correct the mistakes.
3. Determine whether the new machine should be purchased.
Asked Sep 17, 2012
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