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- I know that its the thing to do, insisted Pamela Kincaid, vice president of finance for Colgate Manufacturing. If we are going to be competitive, we need to build this completely automated plant. Im not so sure, replied Bill Thomas, CEO of Colgate. The savings from labor reductions and increased productivity are only 4 million per year. The price tag for this factoryand its a small oneis 45 million. That gives a payback period of more than 11 years. Thats a long time to put the companys money at risk. Yeah, but youre overlooking the savings that well get from the increase in quality, interjected John Simpson, production manager. With this system, we can decrease our waste and our rework time significantly. Those savings are worth another million dollars per year. Another million will only cut the payback to about 9 years, retorted Bill. Ron, youre the marketing managerdo you have any insights? Well, there are other factors to consider, such as service quality and market share. I think that increasing our product quality and improving our delivery service will make us a lot more competitive. I know for a fact that two of our competitors have decided against automation. Thatll give us a shot at their customers, provided our product is of higher quality and we can deliver it faster. I estimate that itll increase our net cash benefits by another 2.4 million. Wow! Now thats impressive, Bill exclaimed, nearly convinced. The payback is now getting down to a reasonable level. I agree, said Pamela, but we do need to be sure that its a sound investment. I know that estimates for construction of the facility have gone as high as 48 million. I also know that the expected residual value, after the 20 years of service we expect to get, is 5 million. I think I had better see if this project can cover our 14% cost of capital. Now wait a minute, Pamela, Bill demanded. You know that I usually insist on a 20% rate of return, especially for a project of this magnitude. Required: 1. Compute the NPV of the project by using the original savings and investment figures. Calculate by using discount rates of 14% and 20%. Include salvage value in the computation. 2. Compute the NPV of the project using the additional benefits noted by the production and marketing managers. Also, use the original cost estimate of 45 million. Again, calculate for both possible discount rates. 3. Compute the NPV of the project using all estimates of cash flows, including the possible initial outlay of 48 million. Calculate by using discount rates of 14% and 20%. 4. CONCEPTUAL CONNECTION If you were making the decision, what would you do? Explain.Gina Ripley, president of Dearing Company, is considering the purchase of a computer-aided manufacturing system. The annual net cash benefits and savings associated with the system are described as follows: The system will cost 9,000,000 and last 10 years. The companys cost of capital is 12 percent. Required: 1. Calculate the payback period for the system. Assume that the company has a policy of only accepting projects with a payback of five years or less. Would the system be acquired? 2. Calculate the NPV and IRR for the project. Should the system be purchasedeven if it does not meet the payback criterion? 3. The project manager reviewed the projected cash flows and pointed out that two items had been missed. First, the system would have a salvage value, net of any tax effects, of 1,000,000 at the end of 10 years. Second, the increased quality and delivery performance would allow the company to increase its market share by 20 percent. This would produce an additional annual net benefit of 300,000. Recalculate the payback period, NPV, and IRR given this new information. (For the IRR computation, initially ignore salvage value.) Does the decision change? Suppose that the salvage value is only half what is projected. Does this make a difference in the outcome? Does salvage value have any real bearing on the companys decision?Flanders Manufacturing is considering purchasing a new machine that will reduce variable costs per part produced by $0.15. The machine will increase fixed costs by $18,250 per year. The information they will use to consider these changes is shown here.
- Hudson Corporation is considering three options for managing its data warehouse: continuing with its own staff, hiring an outside vendor to do the managing, or using a combination of its own staff and an outside vendor. The cost of the operation depends on future demand. The annual cost of each option (in thousands of dollars) depends on demand as follows: If the demand probabilities are 0.2, 0.5, and 0.3, which decision alternative will minimize the expected cost of the data warehouse? What is the expected annual cost associated with that recommendation? Construct a risk profile for the optimal decision in part (a). What is the probability of the cost exceeding $700,000?Covington Pharmacies has decided to automate its insurance claims process. Two networked computer systems are being considered. The systems have an expected life of two years. The net cash flows associated with the systems are as follows. The cash benefits represent the savings created by switching from a manual to an automated system. The companys cost of capital is 10 percent. Required: 1. Compute the NPV and the IRR for each investment. 2. Show that the project with the larger NPV is the correct choice for the company.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 firms 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. Required: 1. Compute the net present value for the old system and the automated system. Which system would the company choose? 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. 5. Given the outcomes of the previous four requirements, comment on the importance of providing accurate inputs for assessing investments in automated manufacturing systems.
- Boxer Production, Inc., is in the process of considering a flexible manufacturing system that will help the company react more swiftly to customer needs. The controller, Mick Morrell, estimated that the system will have a 10-year life and a required return of 10% with a net present value of negative $500,000. Nevertheless, he acknowledges that he did not quantify the potential sales increases that might result from this improvement on the issue of on-time delivery, because it was too difficult to quantify. If there is a general agreement that qualitative factors may offer an additional net cash flow of $150,000 per year, how should Boxer proceed with this Investment?Nico Parts, Inc., produces electronic products with short life cycles (of less than two years). Development has to be rapid, and the profitability of the products is tied strongly to the ability to find designs that will keep production and logistics costs low. Recently, management has also decided that post-purchase costs are important in design decisions. Last month, a proposal for a new product was presented to management. The total market was projected at 200,000 units (for the two-year period). The proposed selling price was 130 per unit. At this price, market share was expected to be 25 percent. The manufacturing and logistics costs were estimated to be 120 per unit. Upon reviewing the projected figures, Brian Metcalf, president of Nico, called in his chief design engineer, Mark Williams, and his marketing manager, Cathy McCourt. The following conversation was recorded: BRIAN: Mark, as you know, we agreed that a profit of 15 per unit is needed for this new product. Also, as I look at the projected market share, 25 percent isnt acceptable. Total profits need to be increased. Cathy, what suggestions do you have? CATHY: Simple. Decrease the selling price to 125 and we expand our market share to 35 percent. To increase total profits, however, we need some cost reductions as well. BRIAN: Youre right. However, keep in mind that I do not want to earn a profit that is less than 15 per unit. MARK: Does that 15 per unit factor in preproduction costs? You know we have already spent 100,000 on developing this product. To lower costs will require more expenditure on development. BRIAN: Good point. No, the projected cost of 120 does not include the 100,000 we have already spent. I do want a design that will provide a 15-per-unit profit, including consideration of preproduction costs. CATHY: I might mention that post-purchase costs are important as well. The current design will impose about 10 per unit for using, maintaining, and disposing our product. Thats about the same as our competitors. If we can reduce that cost to about 5 per unit by designing a better product, we could probably capture about 50 percent of the market. I have just completed a marketing survey at Marks request and have found out that the current design has two features not valued by potential customers. These two features have a projected cost of 6 per unit. However, the price consumers are willing to pay for the product is the same with or without the features. Required: 1. Calculate the target cost associated with the initial 25 percent market share. Does the initial design meet this target? Now calculate the total life-cycle profit that the current (initial) design offers (including preproduction costs). 2. Assume that the two features that are apparently not valued by consumers will be eliminated. Also assume that the selling price is lowered to 125. a. Calculate the target cost for the 125 price and 35 percent market share. b. How much more cost reduction is needed? c. What are the total life-cycle profits now projected for the new product? d. Describe the three general approaches that Nico can take to reduce the projected cost to this new target. Of the three approaches, which is likely to produce the most reduction? 3. Suppose that the Engineering Department has two new designs: Design A and Design B. Both designs eliminate the two nonvalued features. Both designs also reduce production and logistics costs by an additional 8 per unit. Design A, however, leaves post-purchase costs at 10 per unit, while Design B reduces post-purchase costs to 4 per unit. Developing and testing Design A costs an additional 150,000, while Design B costs an additional 300,000. Assuming a price of 125, calculate the total life-cycle profits under each design. Which would you choose? Explain. What if the design you chose cost an additional 500,000 instead of 150,000 or 300,000? Would this have changed your decision? 4. Refer to Requirement 3. For every extra dollar spent on preproduction activities, how much benefit was generated? What does this say about the importance of knowing the linkages between preproduction activities and later activities?Kylies Cookies is considering the purchase of a larger oven that will cost $2,200 and will increase her fixed costs by $59. What would happen if she purchased the new oven to realize the variable cost savings of $0.10 per cookie, and what would happen if she raised her price by just $0.20? She feels confident that such a small price increase will decrease the sales by only 25 units and may help her offset the increase in fixed costs. Given the following current prices how would the break-even in units and dollars change if she doesnt increase the selling price and if she does increase the selling price? Complete the monthly contribution margin income statement for each of these cases.
- Southland Corporation’s decision to produce a new line of recreational products resulted in the need to construct either a small plant or a large plant. The best selection of plant size depends on how the marketplace reacts to the new product line. To conduct an analysis, marketing management has decided to view the possible long-run demand as low, medium, or high. The following payoff table shows the projected profit in millions of dollars: What is the decision to be made, and what is the chance event for Southland’s problem? Construct a decision tree. Recommend a decision based on the use of the optimistic, conservative, and minimax regret approaches.A firm is trying to decide which of two devices to install to reduce costs. Both devices have useful lives of 5 years and no salvage value. Device A costs $10,000 and can be expected to result in $3000 savings annually. Device B costs $13,500 and will provide cost savings of $3000 the first year, but savings will increase by $500 annually, making the second-year savings $3500, the third-year savings $4000, and so forth. With interest at 7%, which device should the firm purchase?You are considering two types of motorcars. Model A costs $182,250 and model B costs$195,000. Although the two models are essentiallythe same, after four years of use, model A can be soldfor $78,400, while model B can be sold for $95,500.Model B commands a better resale value because itsstyling is popular among young executives. Determine the rate of return on the incremental investment of $12,750. For what range of values of yourMARR is model B preferable?
