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Hello,
I would like to ask this doubt I have regarding my homework and i wasn’t sure even after watching the lecture.
It would help if anyone could clarify it as soon as possible.“Fixed costs of production will be $110 000 in the first year irrespective of which machine is purchased. Fixed cost will increase by $10 000 per year for the next three year”.
Machine life is 4 years.
how would you account for this fixed cost when finding NPV?
a)Should you be taking 110,000 in the first year and 120,000 in the second year and so on?
b)Dont take 110000 in the first year because its not an incremental cost but start from 120000 in the second year and so on.
c) take 10000 in the second year and 20000 in the third year and so on.If non of the above is correct, pls tell me which is.
Thanks!
It’s difficult to be sure how to answer this, without seeing a bit more of the context of the question.
Is the purpose to decide which machine to purchase for a new project, or whether to replace an old machine, or something else? Will the company potentially not purchase a machine at all if all options have a negative NPV?
I don’t think you can say definitively that it’s a relevant cash flow just because it says “increase”. If the question was asking you to evaluate replacing a machine and both machines had the same running costs, which increased by $10,000 a year, then it wouldn’t be a relevant cost!
Anyway, assuming it IS a relevant cost, then you would usually do option A and include all of the costs.
But as I said you need to understand the context of the question and what it is asking you. Try to understand WHY you are calculating something and not just what you need to calculate. This will help you avoid making mistakes in the exam, and it’s a skill you’ll need to develop as you progress through ACCA, especially once you get to the Strategic level.
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