The owner of a small printing company is considering the purchase of additional

Question

The owner of a small printing company is considering the purchase of additional printing equipment to expand her business. If the owner expands the business and sales are high, projected profits (minus the cost of the equipment) should be $90,000; if sales are low, projected profits should be $40,000. If the equipment is not purchased, projected profits should be $70,000 if sales are high and $50,000 if sales are low. Are there options other than the purchase of additional equipment that should be considered in making the decision to expand the business? If the owner is optimistic about the company’s future sales, should the company expand by purchasing the equipment? Is the owner’s optimism or pessimism about sales the only factor that may impact the company’s profits? The equipment to be purchased is known in the industry to have a useful life of five years. How might this impact the printing company?

Explanation / Answer

Yes, the owner should evaluate and ponder about the situation a little more than the numbers:-

1. The existng utilization and capacity of the existing system.

2. Outsourcing.

3. Renting the equipment

4. Possibility of demand shift - can she move some printing work to a non-peak period to improve the overal annual utilization of the exixting machinery?

5. ROCE etc.

Printing industry, in particular is a very seasonal industry giving special discounts etc, so that the existing machinery can be better utilized to increase the RoA (Return on Asset employed).

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Though the information available is very limited and inadequeate to make a choice but on prima facie procurement of the equipment does not sound a bad option.

Assuming her procurement of the equipment has insignificant impact on the market: The gains are twice the loss (Incremental gain from increased sales and producton : 90,000-70,000=$20,000 and loss from procurement is50,00-40,000= $10,000)

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No, as mentioned above the owner should consider the above mentioned points before making the investment. Assumption here is that the owner'"s optimism stems from his/her through understanding and awareness about the market and the industry.

Most capital intensive decisions are made after perfoming a feasibility study which comprises of (economic feasibility (NPV), financial feasibility(Availability of funds, ROCE) and technical feasibility) .

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The asset price shpuld not be decreased from the profits at ones but should be depreciated over the 5 year period. thus if the asset costs $x, then the first year reduction using Straight line depreciateion shall be: $x/5 next year another $x/5 and so on...

Thanks!

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