2D2B VERLA INDUSTRIES IS TRYING TO DECIDE WHICH ONE OF THE FOLLOWING...

316.

CSO: 2D2a

LOS: 2D2b

Verla Industries is trying to decide which one of the following two options to pursue.

Either option will take effect on January 1st of the next year.

Option One - Acquire a New Finishing Machine.

The cost of the machine is $1,000,000 and will have a useful life of five years. Net pre-

tax cash flows arising from savings in labor costs will amount to $100,000 per year for

five years. Depreciation expense will be calculated using the straight-line method for

both financial and tax reporting purposes. As an incentive to purchase, Verla will receive

a trade-in allowance of $50,000 on their current fully depreciated finishing machine.

Option Two - Outsource the Finishing Work.

Verla can outsource the work to LM Inc. at a cost of $200,000 per year for five years. If

they outsource, Verla will scrap their current fully depreciated finishing machine.

Verla’s effective income tax rate is 40%. The weighted-average cost of capital is 10%.

The net present value of outsourcing the finishing work is

a.

$303,280 net cash outflow.

b.

$404,920 net cash outflow.

c.

$454,920 net cash outflow.

d.

$758,200 net cash outflow.