Compensation; Net Present Value (see Chapter 12) Kate’s Candy Co. makes chewy chocolate candies at a plant in Winston-Salem, North Carolina. Steve Bishop, the production manager at this facility, installed a packaging machine last year at a cost of $500,000. This machine is expected to last for 10 more years with no residual value. Operating costs for the projected levels of production, before depreciation, are $100,000 annually. Steve has just learned of a new packaging machine that would work much more efficiently in the production line. This machine would cost $580,000 installed, but the annual operating costs would be only $40,000 before depreciation. This machine would be depreciated over 10 years with no residual value. He could sell the current packaging machine this year for $250,000. Steve has worked for Kate’s Candy for 7 years. He plans to remain with the firm for about 2 more years, when he expects to become a vice president of operations at his father-in-law’s company. Kate’s Candy pays Steve a fixed salary with an annual bonus of 5% of net income for the year. Assume that Kate’s Candy uses straight-line depreciation and has a 10% required rate of return. Ignore income tax effects.
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1. As the owner of Kate’s Candy, would you want Steve to keep the current machine or purchase the new one, and why? (Note: Use Excel to calculate the NPV, and round final calculations to the nearest whole dollar.) a. Keep the current machine because the net present value of purchasing the new machine is only $8,744. b. Keep the current machine because the net present value of purchasing the new machine is ($11,502). c. Purchase the new machine because the net present value is $38,674. d. Purchase the new machine because the net present value is $55,080. 2. Why would Steve prefer to not make the decision preferred by the owner of Kate’s Candy? a. Because he has information the owner doesn’t have about the likelihood of success. b. Because his bonus would be reduced by $6,700 in the final 2 years of his employment. c. Because of his risk aversion relative to the owners of Kate’s Candy. d. Because his bonus would be reduced by $4,800 in the final 2 years of his employment.