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Present value of purchasing or renting machinery
The Portsmere Hospital operates its own laundry. Last year the laundry processed 120 000 kilograms of washing and this year the total is forecast to grow to 132 000 kilograms. Tffis growth in laundry processed is forecast to continue at the same percentage rate for the next seven years. Because of this, the hospital must immediately replace its existing laundry equipment. Currently, it is considering two options, the purchase of machine A or the rental of machine B. Information on both options is given below:
|
Machine A — purchase |
|
|
Annual capacity (kilograms) |
180 000 |
|
Material cost per kilogram |
£2.00 |
|
Labour cost per kilogram |
£3.00 |
|
Fixed costs per annum |
£20 000 |
|
Life of machine |
3 years |
|
Capital cost |
£60 000 |
|
Depreciation per annum |
£20 000 |
|
Machine B — rent |
|
|
Annual capacity (kilograms) |
170 000 |
|
Material cost per kilogram |
£1.80 |
|
Labour cost per kilogram |
£3.40 |
|
Fixed costs per annum |
£18 000 |
|
Rental per annum |
£20 000 |
|
Rental agreement |
3 years |
|
Depreciation per annum |
nil |
Other information:
1. The hospital is able to call on an outside laundry if there is either a breakdown or any other reason why the washing cannot be undertaken in-house. The charge would be £10 per kilogram of washing.
2. Machine A, if purchased, would have to be paid for immediately. All other cash flows can be assumed to occur at the end of the year.
3. Machine A will have no residual value at any time.
4. The existing laundry equipment could be sold for £10 000 cash.
5. The fixed costs are a direct cost of operating the laundry.
6. The hospital's discount rate for projects of this nature is 15%.
Task 1
You are an accounting_ technician employed by the Portsmere Hospital and you are asked to write a brief report to its chief executive. Your report should:
(a) evaluate the two options for operating the laundry, using discounted cash flow techniques;
(b) recommend the preferred option and identify one possible non-financial benefit;
(c) justify your treatment of the £10 000 cash value of the existing equipment;
(d) explain what is meant by discounted cashflow.
Note:
Inflation can be ignored.
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