Question 2 Mallette Manufacturing, Inc. produces washing machines, dryers, and d

Question

Question 2

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 ten years. The automated system would also have a useful life of ten 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:

Sales per year (units)

100,000

Selling price

$300

Costs per unit:

    Direct materials

80

    Direct labor

90

    Variable overhead

20

    Direct fixed overhead*

40

* All cash expenses with the exception of depreciation,

which is $6 per unit. The existing equipment is being

depreciated using the straight-line method with no

salvage value considered.

The automated system will cost $34 million to purchase, plus an estimated $20 million in software and implementation. 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 materials 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. Direct labor is reduced by 60 percent.

Other information:

•           if Mallette keeps the old system, sales will drop by 20,000 units to 80,000 units per year

•           the automated equipment could be sold for $4 million at the end of ten years. The software and implementation will have zero salvage value at any time after the implementation

•           the equipment of the old system would have no salvage value at the end of ten years.

•           the firm's cost of capital is 12 percent.

•           the tax rate is 40 percent.

•           the complete software and implementation costs are depreciated for tax purposes over 5 years on the straight-line basis.

•           the automated system will require an initial increase in working capital of $5,000,000 followed by another increase of $2,000,000 at the end of year 5.

•           the automated system cost of $54,000,000 will be depreciated on a straight line basis over 10 years

•           total annual fixed costs for the automated system will be $6,000,000

Required -

Do you recommend that Mallette purchase the automated system? Show detailed calculations.

Help please!

Thanks in advance

Sales per year (units)

100,000

Selling price

$300

Costs per unit:

    Direct materials

80

    Direct labor

90

    Variable overhead

20

    Direct fixed overhead*

40

Explanation / Answer

Year Cash flow under Old system Cash flow under Automated system Difference in cash flows PVIF@12% Present value of difference 0 -300000 -59000000 -56000000 1 -56000000 1 3888000 7872000 3984000 0.892857 3557142.9 2 3888000 7872000 3984000 0.797194 3176020.4 3 3888000 7872000 3984000 0.71178 2835732.5 4 3888000 7872000 3984000 0.635518 2531904 5 3888000 5872000 1984000 0.567427 1125774.9 6 3888000 7872000 3984000 0.506631 2018418.4 7 3888000 7872000 3984000 0.452349 1802159.3 8 3888000 7872000 3984000 0.403883 1609070.8 9 3888000 7872000 3984000 0.36061 1436670.3 10 3648000 18872000 15224000 0.321973 4901720.6 Net Present value -31005386 No, we do not recommend Mallette purchase the automated system as net present value of evaluation is negetive. Units sold 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 7.5 231.5 68.5 27.4 41.1 7.5 48.6 80000 Total 24000000 6400000 7200000 1600000 2720000 600000 18520000 5480000 2192000 3288000 600000 3888000 Automated system 100000 Per Unit 300 60 36 16 60 54 226 74 29.6 44.4 54 98.4 Total 30000000 6000000 3600000 1600000 6000000 5400000 22600000 5920000 2368000 3552000 4320000 7872000

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