Fresh Flour makes baking flour and sells its flour in 4 pound sacks or bags. The managers of Fresh Flour are considering whether the firm should make or buy the flour sacks. To make the sacks, Fresh Flour needs a $500,000 piece of equipment. Using this equipment, Fresh Flour can make a flour sack for $0.01 and, for simplicity, ignore taxes and assume that the $0.01 cost includes depreciation and all other costs. Fresh Flour would finance the $500,000 investment using its own funds and, if it purchased the flour sacks from another firm, it would pay $0.19 a flour sack. The life span of the equipment is 10 years and it has no salvage value at the end of the ten years. If the discount rate is 6 percent and the firm needs 400,000 flour sacks a year, what is the present value of the equipment?
A)$459,250
B)$500,962
C)$623,850
D)$529,926

Question

Quizplus · Accepted Answer

To calculate the present value (PV) of the equipment, we need to compare the cost of making sacks in-house versus buying them. The annual savings from making the sacks in-house is the difference between the cost of buying sacks externally and the cost of making them, multiplied by the number of sacks needed per year.Annual savings = (Cost of buying - Cost of making) * Number of sacks= ($0.19 - $0.01) * 400,000= $0.18 * 400,000= $72,000The present value of these annual savings over the 10-year life of the equipment, discounted at a 6% rate, can be calculated using the formula for the present value of an annuity:PV = P * [(1 - (1 + r)^-n) / r]where P is the annual payment (savings), r is the discount rate, and n is the number of periods.PV = $72,000 * [(1 - (1 + 0.06)^-10) / 0.06]= $72,000 * [1 - (1.06)^-10] / 0.06= $72,000 * [1 - 0.5584] / 0.06= $72,000 * 0.4416 / 0.06= $72,000 * 7.3601= $529,927.2Rounding to the nearest dollar, the present value of the equipment is approximately $529,926, which corresponds to option D.

Fresh Flour Makes Baking Flour and Sells Its Flour in 4