## Tuesday, 31 March 2015

### Wendell’s Donut Shoppe is investigating the purchase of a new \$42,700 donut-making machine. The new machine would permit the company to reduce the amount of part-time help needed, at a cost savings of \$6,400 per year. In addition, the new machine would allow the company to produce one new style of donut, resulting in the sale of 2,400 dozen more donuts each year. The company realizes a contribution margin of \$2.00 per dozen donuts sold. The new machine would have a six-year useful life.

Wendell’s Donut Shoppe is investigating the purchase of a new \$42,700 donut-making machine. The new machine would permit the company to reduce the amount of part-time help needed, at a cost savings of \$6,400 per year. In addition, the new machine would allow the company to produce one new style of donut, resulting in the sale of 2,400 dozen more donuts each year. The company realizes a contribution margin of \$2.00 per dozen donuts sold. The new machine would have a six-year useful life.
 Required: 1. What would be the total annual cash inflows associated with the new machine for capital budgeting purposes?

Explanation:
1.
 Added contribution margin from expanded sales: 2,400 dozen × \$2.00 per dozen = \$4,800.

2.
 Looking in Exhibit 13B-2, a factor of 3.813 falls closest to the 15% rate of return.

3.
 The cash flows will not be even over the six-year life of the machine because of the extra \$13,000 inflow in the sixth year. Therefore, the above approach cannot be used to compute the internal rate of return in this situation. Using trial-and-error or some other method, the internal rate is 19%:

 Now 1 2 3 4 5 6 Purchase of machine \$ (42,700) Reduced part-time help \$ 6,400 \$ 6,400 \$ 6,400 \$ 6,400 \$ 6,400 \$ 6,400 Added contribution margin 4,800 4,800 4,800 4,800 4,800 4,800 Salvage value of machine 13,000 Total cash flows (a) (42,700) \$ 11,200 \$ 11,200 \$ 11,200 \$ 11,200 \$ 11,200 \$ 24,200 Discount factor (19%) (b) 1.000 0.840 0.706 0.593 0.499 0.419 0.352 Present value (a) × (b) \$ (42,700) \$ 9,408 \$ 7,907 \$ 6,642 \$ 5,589 \$ 4,693 \$ 8,518 Net present value \$ 0