Lego Group in Bellund, Denmark manufactures Lego toy construction blocks. The company is con­sidering two methods for producing special-purpose Lego parts. Method 1 will have an initial cost of $400,000, an annual operating cost of $140,000, and a life of 3 years. Method 2 will have an initial cost of $600,000, an operating cost of $100,000 per year, and a 6-year life. Assume 10% salvage values for both methods. Lego uses an MARR of 15% per year. (a) Which method should it select on the basis of a present worth analysis? (b) If the evaluation is incor­rectly performed using the respective life estimates of 3 and 6 years, will Lego make a correct or incor­rect economic decision? Explain your answer.

Question

What will be an ideal response?

Answer 1

(a) PW1 = -400,000 – 140,000(P/A,15%,6)-360,000(P/F,15%,3)+ 40,000(P/F,15%,6)
= -400,000 – 140,000(3.7845) – 360,000(0.6575) + 40,000(0.4323)
= $-1,149,238

PW2 = -600,000 – 100,000(P/A,15%,6) + 60,000(P/F,15%,6)
= -600,000 – 100,000(3.7845) + 60,000(0.4323)
= $-952,512

Select method 2
(b) Incorrect PW1 over 3 years, PW2 is correct in (a)

Incorrect PW1 = -400,000 – 140,000(P/A,15%,3) + 40,000(P/F,15%,3)
= -400,000 – 140,000(2.2832) + 40,000(0.6575)
= $-693,348

Correct PW2 = -600,000 – 100,000(P/A,15%,6) + 60,000(P/F,15%,6)
= -600,000 – 100,000(3.7845) + 60,000(0.4323)
= $-952,512

Select method 1, which is an economically incorrect decision for Lego. The analysis does not meet the equal-service requirement of PW analysis.