Frawley Products Company The Frawley Products Company is a plastic injection mol
ID: 2598098 • Letter: F
Question
Frawley Products Company
The Frawley Products Company is a plastic injection molding business located in Frankfort, Indiana. The company was started in 1965 by Ms. Tracy Do, an Indiana entrepreneur. Frawley’s sells molded parts to first and second tier suppliers in the auto industry. Fifty percent of its sales are to the Subaru Isuzu plant in nearby Lafayette, Indiana. The close proximity of the Subaru plant to Frawley has kept shipping costs low and has helped Frawley to be cost competitive. But Subaru is putting tremendous pressure on all of its suppliers to reduce costs.
Frawley’s management is concerned about the company’s ability over the longer term to maintain production in Indiana given competitors’ costs. Management has found that an item that costs $1.00 to make in Frankfort costs $0.40 if sourced from Mexico and $0.20 if sourced from China. Management recognizes that major changes are needed in Frawley’s manufacturing processes for the company to remain competitive while continuing to be located in Indiana. Management has decided to consider investing in new technology next year.
Plastic Production Upgrade
The technology under consideration involves replacing existing plastic molding machines. For one of its product lines, the company uses three plastic molding machines that have an aggregate book value of $600,000. These machines are being depreciated to zero on a straight-line basis and have three years of depreciable life remaining. The item for which these machines are used will be produced for another five years and then discontinued. With proper maintenance, the existing equipment will last for the five years remaining in the life of the project. At the end of five years from today the equipment is expected to have a resale value of $50,000. If these machines are sold today, their resale value will be $250,000.
Replacement equipment will require the expenditure of $750,000 now and another $750,000 at the beginning of next year. For tax purposes, management can choose to write off these expenditures in the year they are incurred, or to capitalize them and depreciate them over five years using the MACRS depreciation schedule (You need to decide which alternative is the best!). At the end of life of the project, the machines are expected to have a resale value of $250,000 combined.
Last year, sales of this product line were $7 million. Management expects unit sales volume and price per unit will be constant in future years. Management expects this project to have a life of five years with or without the new equipment. However, the new equipment will reduce the cost of goods sold by six percent of sales. These are reductions in costs relative to the cost of production with the existing equipment.
The new equipment will free up 4,000 square feet of space on the production floor and will reduce the allocated overhead expense attributable to the plastic molding production line by $50,000 per year because of the smaller space allocated to the line. Management has no use for this freed up space.
One component of the new equipment involves installation of an electronic monitoring device. For this reason, an electronics technician will have to be assigned to the line if the new equipment is installed. The equipment will only require about 50% of the time of such a technician. The cost of a full-time technician is $100,000 annually. As it turns out, an in-house electronics technician is only partially used by another product line, and she can be assigned to the new equipment for 1/2 of her time. The manager for the project on which she is now working is very excited about this prospect because this means that only 50% of the technician’s salary will be attributed to his department in the future.
The new equipment requires additional Net Working Capital of 170,700 immediately (year zero), which will be recovered at the end of 5 years.
The company’s tax rate is 35 percent and will be for the foreseeable future. Additionally, Mr. Jose believes that Frawley has sufficient pre-tax earnings to be able to use all depreciation tax shields and write-offs that are created by the two projects.
Exhibit 1
3 yr. MACRS Depreciation
Schedule
Year
3-Year
1
.3333
2
.4445
3
.1481
4
.0741
Write down incremental cash flows from replacing the old machine with the new one. (No need to calculate NPV)
Schedule
Year
3-Year
1
.3333
2
.4445
3
.1481
4
.0741
Explanation / Answer
1. Calculation of Incremental Cash flows from replacing the machine.
Alternative of booking capital expenditure in the year incurred
Particulars
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Capital Expenditure
(750,000)
(750,000)
Working Capital
(170,700)
170,700
Net Resale value of old machine
(250,000 – 50,000)
200,000
Savings of Cost of goods sold (Net of Tax)
(7 Million x 6%) (1-.35)
273,000
273,000
273,000
273,000
273,000
Savings in overhead expenses (Net of tax)
(50,000) (1-.35)
32,500
32,500
32,500
32,500
32,500
Salary of technician net of tax
(50,000) (1-.35)
(32,500)
(32,500)
(32,500)
(32,500)
(32,500)
Resale Value of new equipment
250,000
Tax savings on expenditure
(750,000 x 35%)
262,500
262,500
Tax not saved on depreciation of old machine
(600,000 / 3 x 35%)
(70,000)
(70,000)
(70,000)
Net Cash Flow
(720,700)
(284,500)
465,500
203,000
273,000
693,700
Net Incremental Cash flow = $662,500
Alternative of booking capital expenditure and then claiming depreciation
Particulars
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Capital Expenditure
(750,000)
(750,000)
Working Capital
(170,700)
170,700
Net Resale value of old machine
(250,000 – 50,000)
200,000
Savings of Cost of goods sold (Net of Tax)
(7 Million x 6%) (1-.35)
273,000
273,000
273,000
273,000
273,000
Savings in overhead expenses (Net of tax)
(50,000) (1-.35)
32,500
32,500
32,500
32,500
32,500
Salary of technician net of tax
(50,000) (1-.35)
(32,500)
(32,500)
(32,500)
(32,500)
(32,500)
Resale Value of new equipment
250,000
Tax savings on depreciation of new machine.(Refer Note Below)
87491.25
204172.5
155557.5
58327.5
19451.25
Tax not saved on depreciation of old machine
(600,000 / 3 x 35%)
(70,000)
(70,000)
(70,000)
Net Cash Flow
(720,700)
(459508.75)
407172.5
358557.5
331327.5
713151.25
Net Incremental Cash flow = $630,000
Note: Calculation of depreciation on new machine
Expenditure of $750,000 now
Year
Value
Percentage
Depreciation
Tax Savings
1
750,000
.3333
249975
87491.25
2
750,000
.4445
333375
116681.25
3
750,000
.1481
111075
38876.25
4
750,000
.0741
55575
19451.25
Expenditure of $750,000 at year 1
Year
Value
Percentage
Depreciation
Tax Savings
2
750,000
.3333
249975
87491.25
3
750,000
.4445
333375
116681.25
4
750,000
.1481
111075
38876.25
5
750,000
.0741
55575
19451.25
Total Tax Savings
Year
Amount
1
87491.25
2
204172.5
3
155557.5
4
58327.5
5
19451.25
From the above computation, the company should book the enpediture in the year it is incurred and claim deduction of same in that year only. Incremental cash flow will be $662,500.
NOTE: We have not taken capital gains tax on resale of machines as the same is not given in the question. Moreover, in the question $250,000 on combined sale of machine is interpreted as sale of only new machine as old one is already sold today for $250,000.
Particulars
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Capital Expenditure
(750,000)
(750,000)
Working Capital
(170,700)
170,700
Net Resale value of old machine
(250,000 – 50,000)
200,000
Savings of Cost of goods sold (Net of Tax)
(7 Million x 6%) (1-.35)
273,000
273,000
273,000
273,000
273,000
Savings in overhead expenses (Net of tax)
(50,000) (1-.35)
32,500
32,500
32,500
32,500
32,500
Salary of technician net of tax
(50,000) (1-.35)
(32,500)
(32,500)
(32,500)
(32,500)
(32,500)
Resale Value of new equipment
250,000
Tax savings on expenditure
(750,000 x 35%)
262,500
262,500
Tax not saved on depreciation of old machine
(600,000 / 3 x 35%)
(70,000)
(70,000)
(70,000)
Net Cash Flow
(720,700)
(284,500)
465,500
203,000
273,000
693,700
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