# 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. 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.

### Cornerstones of Cost Management (C...

4th Edition
Don R. Hansen + 1 other
Publisher: Cengage Learning
ISBN: 9781305970663

Chapter
Section

### Cornerstones of Cost Management (C...

4th Edition
Don R. Hansen + 1 other
Publisher: Cengage Learning
ISBN: 9781305970663
Chapter 19, Problem 30P
Textbook Problem
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## 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.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.

1.

To determine

Ascertain the net present value for both the old and automated system, and state the system that the company would choose.

### Explanation of Solution

Net present value method (NVP): Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is desired by the business based on the net income from the investment, and it is also called as the discounted cash flow method.

Ascertain the net present value for both the old and automated system, and state the system that the company would choose:

For Old system (in thousands):

 Year Revenue Expenses Depreciation after tax Cash flow Discount factor @ 20% Present value (1) (a) (2) (b) (3) (c) (d=a+b+c) (e) (d×e) 1 $18,000 ($13,440) $240 4,800 0.833 3,998 2$18,000 ($13,440)$240 4,800 0.694 3,331 3 $18,000 ($13,440) $240 4,800 0.579 2,779 4$18,000 ($13,440)$240 4,800 0.482 2,314 5 $18,000 ($13,440) $240 4,800 0.402 1,930 6$18,000 ($13,440)$240 4,800 0.335 1,608 7 $18,000 ($13,440) $240 4,800 0.279 1,339 8$18,000 ($13,440)$240 4,800 0.233 1,118 9 $18,000 ($13,440) $240 4,800 0.194 931 10$18,000 ($13,440) - 4,560 0.162 739 20,088 Less: Initial investment 0 Net present value 20,088 Table (1) Working note (1): Compute the amount of revenue: Revenue=[(Total sales×selling price)×(1Tax rate)]=$100,000×$300×(140100)=$18,000,000

Working note (2):

Compute the amount of expense:

Expenses=[(Total sales unit×Total cost)×(1Tax rate)]=[$100,000×($80+$90+$20+$34)×(140100)]=$13,440,000

Working note (3):

Compute the amount of after tax depreciation expense:

Depreciation Expenses=[Acquisition costSalvage value Estimated life×Tax rate]=[$6,000,000010×40100]=[$600,000×0.4]=$240,000 For New system (in thousands):  Year Revenue Expenses Depreciation after tax Cash flow Discount factor Present value (1) (a) (4) (b) (6) (c) (d=a+b+c) (e) (d×e) 0 (50,040) (7) 1.000$(50,040) 1 $18,000 ($7,740) $2,160 12,420 0.833 3,998 2$18,000 ($7,740)$2,160 12,420 0

2.

To determine

Ascertain the net present value for both the old and automated system under 12% discount rate, and state the system that the company would choose.

3.

To determine

Ascertain the net present value for the 12% discount rate using this given information.

4.

To determine

Ascertain the net present value for the given analysis; use the information in Requirement 3,

5.

To determine

Interpret the significance of providing accurate inputs for evaluating investments in automated manufacturing systems.

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