Several years ago, Catherine's Cattery Business signed a contract to supply 5000 units of a special product each year to one of its customers at a price of \(\$ 15\) per unit. This contract, which runs for five more years, is non-cancellable.

Catherine is currently producing the product with an old machine that can be kept running for five more years if \(\$ 9000\) of maintenance cost per year is incurred. Other operating costs to produce this product with the old machine (excluding maintenance) total \(\$ 45000\) per year. The old machine has no residual value now and will have none after the contract is fulfilled.

Pedro's Pet Products Business has recently offered to sell Catherine 5000 units of this product per year over the next five years for \(\$ 10.50\) per unit. Catherine had almost decided to accept this offer from Pedro as the best possible way to satisfy its contract when a new machine capable of producing the 5000 units each year for \(\$ 42000\) total cash operating costs per year became available. This new machine would cost \(\$ 41250\) and would have a residual value of \(\$ 7500\) after five years. Catherine's required rate of return is 16 per cent.

Required:

a Is purchasing 5000 units of the product per year from Pedro's Pet Products Business preferable to producing them on the old machine? Explain.

b By calculating the net present value of this proposal, determine the acceptability of the capital expenditure proposal to buy the new machine.

c If Pedro's Pet Products Business withdraws its offer to supply the units, would your answer to

(b) change? Explain, supporting your explanation with calculations if necessary.