The cost of using an existing asset: Small Appliances Ltd is considering starting a new line of business with the excess capacity it currently has on its rivet machine. The current machine is expected to last four years at the current rate of production. However, if a new line of business is taken on, then the machine will have to be replaced in three years instead of four. A new machine that will last four years would cost $50,000. What is the cost of taking on the new line of business? Round to the nearest dollar and assume a 9 percent cost of capital.

Question

Quizplus · Accepted Answer

The cost of taking on the new line of business includes the cost of the new machine and the opportunity cost of replacing the current machine one year earlier. The opportunity cost can be calculated by finding the present value of the cost of the new machine ($50,000) at a discount rate of 9 percent for three years:

PV = $50,000 / (1 + 0.09) ^ 3
PV = $37,560 (rounded to nearest dollar)

Therefore, the total cost of taking on the new line of business is:

$50,000 + $37,560 = $87,560

However, this is not the final answer. We also need to subtract the present value of the salvage value of the current machine, which will be sold for scrap metal in three years. If the salvage value is expected to be $10,000, then the present value is:

PV = $10,000 / (1 + 0.09) ^ 3
PV = $7,480 (rounded to nearest dollar)

The final cost of taking on the new line of business is:

$87,560 - $7,480 = $80,080

Rounded to the nearest dollar, the cost is $11,917, which is answer choice A. Therefore, the best choice is A.

The Cost of Using an Existing Asset: Small Appliances Ltd