Capital Investment, Discount Rates, Intangible and Indirect Benefits, Time Horiz

Question

Capital Investment, Discount Rates, Intangible and Indirect Benefits, Time Horizon, Contemporary Manufacturing Environment

Mallette Manufacturing, Inc., produces washing machines, dryers, and dishwashers. Because of increasing competition, Mallette is considering investing in an automated manufacturing system. Since competition is most keen for dishwashers, the production process for this line has been selected for initial evaluation. The automated system for the dishwasher line would replace an existing system (purchased one year ago for $6 million). Although the existing system will be fully depreciated in nine years, it is expected to last another 10 years. The automated system would also have a useful life of 10 years.

The existing system is capable of producing 100,000 dishwashers per year. Sales and production data using the existing system are provided by the Accounting Department:

*All cash expenses with the exception of depreciation, which is $6 per unit. The existing equipment is being depreciated using straight-line with no salvage value considered.

The automated system will cost $34 million to purchase, plus an estimated $20 million in software and implementation. (Assume that all investment outlays occur at the beginning of the first year.) If the automated equipment is purchased, the old equipment can be sold for $3 million.

The automated system will require fewer parts for production and will produce with less waste. Because of this, the direct material cost per unit will be reduced by 25 percent. Automation will also require fewer support activities, and as a consequence, volume-related overhead will be reduced by $4 per unit and direct fixed overhead (other than depreciation) by $17 per unit. Direct labor is reduced by 60 percent. Assume, for simplicity, that the new investment will be depreciated on a pure straight-line basis for tax purposes with no salvage value. Ignore the half-life convention.

The firm’s cost of capital is 12 percent, but management chooses to use 20 percent as the required rate of return for evaluation of investments. The combined federal and state tax rate is 40 percent.

The present value tables provided in Exhibit 19B.1 and Exhibit 19B.2 must be used to solve the following problems.

Required:

1. Compute the net present value for the old system and the automated system.

Which system would the company choose?
Old system

2. Repeat the net present value analysis of Requirement 1, using 12 percent as the discount rate.

3. Upon seeing the projected sales for the old system, the marketing manager commented: “Sales of 100,000 units per year cannot be maintained in the current competitive environment for more than one year unless we buy the automated system. The automated system will allow us to compete on the basis of quality and lead time. If we keep the old system, our sales will drop by 10,000 units per year.” Repeat the net present value analysis, using this new information and a 12 percent discount rate.

4. An industrial engineer for Mallette noticed that salvage value for the automated equipment had not been included in the analysis. He estimated that the equipment could be sold for $4 million at the end of 10 years. He also estimated that the equipment of the old system would have no salvage value at the end of 10 years. Repeat the net present value analysis using this information, the information in Requirement 3, and a 12 percent discount rate.

NPV = $__

Sales per year (units) 100,000 Selling price $300 Costs per unit:    Direct materials 80    Direct labor 90    Volume-related overhead 20 Direct fixed overhead 40* EXHIBIT 19B.2 Present Value of an Annuity of $1 in Arrears* Periods 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% 32% 40% | 0.980 0.9620.943 0.926 0.909 0.893 1.942 1.866 1.833 1.783 1.736 1.690 2.884 2.775 2.673 2.577 2.487 2.402 3.808 3.630 3.4653.312 3.170 3.037 4.713 4.452 4.212 3.993 3.791 5.601 5.242 4.917 4.623 4.355 4.111 6.472 6.002 5.582 5.206 4.868 4.564 7.325 6.733 6.210 5.747 5.335 4.968 8.162 7.435 6.802 6.247 5.759 5.328 8.983 8.111 7.360 6.710 6.145 5.650 9.787 8.760 7.887 7.139 6.495 5.938 10.575 9.385 8.384 7.536 6.814 6.194 11.348 9.986 8.853 7.904 7.103 6.424 9.295 8.244 7.367 6.628 12.849 11.118 9.712 8.559 7.606 6.811 13.578 11.652 10.106 8.851 7.824 6.974 14.292 12166 10.477 9.122 8.022 7.120 14.992 12.659 10.828 9.372 8.2017.250 15.678 13.134 11.158 9.604 8.365 7.366 16.351 13.590 11.470 9.818 8.514 7.469 17.011 14.029 11.764 10.017 8.649 7.562 17.658 14.451 12.042 10.201 8.772 7.645 18.292 14.857 12.303 10.371 8.883 7.718 18.914 15.247 12.550 10.529 8.985 7.784 19.523 15.622 12.783 10.675 9.077 7.843 20.121 15.983 13.003 10.810 9.161 7.896 20.707 16.330 13.211 10.935 9.237 7.943 21.281 16.663 13.406 11.051 9.307 7.984 21.844 16.984 13.591 11.158 9.370 8.022 22.39% 17.292 13.765 11.258 9.427 8.055 0.714 1.224 1.589 1.849 2.035 2.168 2.263 2.331 2.379 2.414 2.438 2.456 2.469 2.478 0.877 0.862 1.647 1.605 2.322 2.246 2.914 2.798 3.433 3.274 3.889 3.685 4.288 4.039 4.639 4.344 4.946 4.607 5.216 4.833 5.453 5.029 5.660 5.197 5.842 5.342 6.002 5.468 6.142 5.575 6.265 5.668 6.373 5.749 6.467 5.818 6.550 5.877 6.623 5.929 6.687 5.973 6.743 6.011 6.792 6.044 6.835 6.073 6.873 6.0 6.906 6.118 6.935 6.136 6.961 6.152 6.983 6.166 7.003 6.177 0.847 1.566 2.174 2.690 3.127 3.498 3.812 3.078 4.303 4.494 4.656 4.793 4.910 5.008 5.092 5.162 5.162 5.222 5.273 5.316 5.353 5.384 5.410 5.432 5.451 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675 4.730 4.730 4.775 4.812 4.843 4.870 4.891 4.909 4.925 4.937 4.948 4.956 4.964 4.970 4.975 4.979 0.820 1.492 2.042 2.494 2.864 3.167 3.416 3.619 3.786 3.923 4.035 4.127 4.203 4.265 4.315 4.357 4.357 4.391 4.419 4.442 4.460 4.476 4.488 4.499 4.507 4.514 4.520 4.524 4.528 4.531 4.534 0.806 0.794 1.457 1.424 1.9811.923 2.404 2.320 2.745 2.635 3.020 2.885 3.242 3.083 3.421 3.241 3.566 3.366 3.682 3.465 3.776 3.543 3.851 3.606 3.9123.656 3.962 3.695 4.001 3.726 4.033 3.751 4.059 3.771 4.080 3.786 4.097 3.799 4.110 3.808 4.121 3.816 4.130 3.822 4.137 3.827 4.143 3.831 4.147 3.834 4.151 3.837 4.154 3.839 4.157 3.840 4.159 3.841 4.160 3.842 0.781 1.392 1.868 2.241 2.532 2.759 2.937 3.076 3.184 3.269 3.335 3.387 3.427 3.459 3.483 3.503 3.518 3.529 3.539 3.546 3.551 3.556 3.559 3.562 3.564 3.566 3.567 3.568 3.569 3.569 0.769 0.758 1.361 1.331 1.8161.766 2.166 2.096 2.436 2.345 2.643 2.534 2.802 2.677 2.925 2.786 3.019 2.868 3.092 2.930 3.147 2.978 3.190 3.013 3.223 3.040 3.249 3.061 3.268 3.076 3.283 3.088 3.295 3.097 3,304 3.104 3.311 3.109 3.316 3.113 3.320 3.116 3.118 3.325 3.120 3.327 3.121 3.329 3.122 3.330 3.123 3.331 3.123 3.331 3.124 3.332 3.332 3.124 2.492 20 2.496 2.497 2.498 2.498 2.499 2.499 2.499 2.500 2.500 2.500 2.500 2.500 5.480 5.492 5.502 5.510 5.517 3.124 *P = (1/0) X [1 - 1/(1 + i)".

Explanation / Answer

Computation of net present value Year Cash flow under Old system Cash flow under Automated system PVIF@20% Present Value of old system Present value of Automated system 0 -5454545* -51000000 1 -5454545.5 -51000000 1 4800000 12420000 0.833333 4000000 10350000 2 4800000 12420000 0.694444 3333333.3 8625000 3 4800000 12420000 0.578704 2777777.8 7187500 4 4800000 12420000 0.482253 2314814.8 5989583.33 5 4800000 12420000 0.401878 1929012.3 4991319.44 6 4800000 12420000 0.334898 1607510.3 4159432.87 7 4800000 12420000 0.279082 1339591.9 3466194.06 8 4800000 12420000 0.232568 1116326.6 2888495.05 9 4560000** 12420000 0.193807 883758.55 2407079.21 10 4560000** 12420000 0.161506 736465.46 2005899.34 Net Present value 14584046 1070503.3 *Note = 6000000*10/11 The reason for this is equipment has total life of 11 years out of which 1 year has elasped Though for depreciation purpose it has different book value, we have used the above as initial investment **Note = The amount has been arrived after reducing the depreciation effect as we will not get depreciation in the year 9 & 10 The Company should choose old system as it has higher Net present value. Requirement 2 Net present value analysis using 12% discount rate Year Cash flow under Old system Cash flow under Automated system PVIF@12% Present Value of old system Present value of Automated system 0 -5454545 -51000000 1 -5454545.5 -51000000 1 4800000 12420000 0.892857 4285714.3 11089285.7 2 4800000 12420000 0.797194 3826530.6 9901147.96 3 4800000 12420000 0.71178 3416545.2 8840310.68 4 4800000 12420000 0.635518 3050486.8 7893134.53 5 4800000 12420000 0.567427 2723648.9 7047441.55 6 4800000 12420000 0.506631 2431829.4 6292358.53 7 4800000 12420000 0.452349 2171276.2 5618177.25 8 4800000 12420000 0.403883 1938639.5 5016229.69 9 4560000 12420000 0.36061 1644381.7 4478776.51 10 4560000 12420000 0.321973 1468198 3998907.6 Net Present value 21502705 19175770 Requirement 3 Net present Value after projection of marketing manager Year No. of units sold Cash flow under Old system without Depreciation effect PVIF@12% Present Value of old system 0 -5454545 1 -5454545.5 1 100000 4800000 0.892857 4285714.3 2 90000 4344000 0.797194 3463010.2 3 80000 3888000 0.71178 2767401.6 4 70000 3432000 0.635518 2181098 5 60000 2976000 0.567427 1688662.3 6 50000 2520000 0.506631 1276710.4 7 40000 2064000 0.452349 933648.78 8 30000 1608000 0.403883 649444.23 9 20000 912000 0.36061 328876.34 10 10000 456000 0.321973 146819.8 Net Present value 12266841 Requirement 4 Net present value after Industrial Engineer's observation Year No. of units sold Cash flow under Old system Cash flow under Automated system PVIF@12% Present Value of old system Present value of Automated system 0 -5454545 -51000000 1 -5454545.5 -51000000 1 100000 4800000 12420000 0.892857 4285714.3 11089285.7 2 90000 4344000 12420000 0.797194 3463010.2 9901147.96 3 80000 3888000 12420000 0.71178 2767401.6 8840310.68 4 70000 3432000 12420000 0.635518 2181098 7893134.53 5 60000 2976000 12420000 0.567427 1688662.3 7047441.55 6 50000 2520000 12420000 0.506631 1276710.4 6292358.53 7 40000 2064000 12420000 0.452349 933648.78 5618177.25 8 30000 1608000 12420000 0.403883 649444.23 5016229.69 9 20000 912000 12420000 0.36061 328876.34 4478776.51 10 10000 456000 12420000 0.321973 146819.8 3998907.6 10 4000000 0.321973 1287892.9 Net Present value 12266841 20463663 Net Present Value of the new system will increase to 20463663 Net present value of old system will remain unchanged to 12266841 Working Notes for answering the requirement units 100000 Sales Direct materials Direct Labor Volume related overhead Direct fixed overhead Depreciation Total Cost of production Operating Income Tax on operating Income Operating Income after tax Add : Depreciation as its non cash item Total cash inflow Old system Per Unit 300 80 90 20 34 6 230 70 28 42 6 48 Total 30000000 8000000 9000000 2000000 3400000 600000 23000000 7000000 2800000 4200000 600000 4800000 Automated system Per Unit 300 60 36 16 17 54 183 117 46.8 70.2 54 124.2 Total 30000000 6000000 3600000 1600000 1700000 5400000 18300000 11700000 4680000 7020000 5400000 12420000 Sales Year Direct materials Direct Labor Volume related overhead Direct fixed overhead-depreciation Depreciation Total Cost of production Operating Income Tax on operating Income Operating Income after tax Add : Depreciation as its non cash item Total cash inflow Unit sold Old system Per Unit 300 80 90 20 34 100000 Total 30000000 1 8000000 9000000 2000000 3400000 600000 23000000 7000000 2800000 4200000 600000 4800000 90000 27000000 2 7200000 8100000 1800000 3060000 600000 20760000 6240000 2496000 3744000 600000 4344000 80000 24000000 3 6400000 7200000 1600000 2720000 600000 18520000 5480000 2192000 3288000 600000 3888000 70000 21000000 4 5600000 6300000 1400000 2380000 600000 16280000 4720000 1888000 2832000 600000 3432000 60000 18000000 5 4800000 5400000 1200000 2040000 600000 14040000 3960000 1584000 2376000 600000 2976000 50000 15000000 6 4000000 4500000 1000000 1700000 600000 11800000 3200000 1280000 1920000 600000 2520000 40000 12000000 7 3200000 3600000 800000 1360000 600000 9560000 2440000 976000 1464000 600000 2064000 30000 9000000 8 2400000 2700000 600000 1020000 600000 7320000 1680000 672000 1008000 600000 1608000 20000 6000000 9 1600000 1800000 400000 680000 0 4480000 1520000 608000 912000 912000 10000 3000000 10 800000 900000 200000 340000 0 2240000 760000 304000 456000 456000

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