“I know that it’s 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.”
“I’m 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 factory—and it’s a small one—is $45 million. That gives a payback period of more than 11 years. That’s a long time to put the company’s money at risk.”
“Yeah, but you’re overlooking the savings that we’ll 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, you’re the marketing manager—do 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. That’ll give us a shot at their customers, provided our product is of higher quality and we can deliver it faster. I estimate that it’ll increase our net cash benefits by another $2.4 million.”
“Wow! Now that’s 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 it’s 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%
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.
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Chapter 12 Solutions
Managerial Accounting: The Cornerstone of Business Decision-Making
- "In my opinion, we ought to stop making our own drums and accept that outside supplier's offer," said Wim Niewindt, managing director of Antilles Refining, N.V., of Aruba. "At a price of $20 per drum, we would be paying $4.45 less than it costs us to manufacture the drums in our own plant. Since we use 65,000 drums a year, that would be an annual cost savings of $289,250," Antilles Refining's current cost to manufacture one drum is given below (based on 65,000 drums per year): Direct materials $10.95 Direct labor 7.00 Variable overhead 1.60 Fixed overhead ($2.50 general company overhead, $1.60 depreciation, and $0.80 supervision) 4.90 Total cost per drun $24.45 A decision about whether to make or buy the drums is especially important at this time because the equipment being used to make the drums is completely worn out and must be replaced. The choices facing the company are: Alternative 1: Rent new equipment and continue to make the drums. The equipment would be rented for $156,000…arrow_forward"We ought to stop making our own drums and accept that outside supplier's offer," said Wim Niewindt, managing director of Antilles Refining, N.V., of Aruba. "At a price of $20 per drum, we would be paying $5.45 less than it costs us to manufacture the drums in our own plant. Because we use 80,000 drums a year, that equals an annual cost savings of $436,000." Antilles Refining's current cost to manufacture one drum is given below (based on 80,000 drums per year): Direct materials Direct labor Variable overhead Fixed overhead ($2.90 general company overhead, $1.80 depreciation, and $0.75 supervision) Total cost per drum A decision about whether to make or buy the drums is especially important at this time because the equipment used to make the drums is completely worn out and must be replaced. The choices facing the company are: $ 12.00 6.50 1.50 Alternative 1: Rent new equipment and continue to make the drums. The equipment would be rented for $180,000 per year. Alternative 2: Purchase…arrow_forwardA bicycle manufacturer currently produces 360,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $268,000 and would be obsolete after ten years. This investment could be depreciated to zero for tax purposes using a ten-year straight-line depreciation schedule. The plant manager estimates that the operation would require $56,000 of inventory and other working capital upfront (year 0), but argues that this sum can be ignored since it is recoverable at the end of the ten years. Expected proceeds from scrapping the machinery after ten years are $20,100.If the company pays tax at a rate of 20% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the…arrow_forward
- A bicycle manufacturer currently produces 282,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $1.80 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.60 per chain. The necessary machinery would cost $225,000 and would be obsolete after ten years. This investment could be depreciated to zero for tax purposes using a ten-year straight-line depreciation schedule. The plant manager estimates that the operation would require $32,000 of inventory and other working capital upfront (year 0), but argues that this sum can be ignored since it is recoverable at the end of the ten years. Expected proceeds from scrapping the machinery after ten years are $16,875. If the company pays tax at a rate of 20% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the…arrow_forwardI’m not sure we should lay out $355,000 for that automated welding machine,” said Jim Alder, president of the Superior Equipment Company. “That’s a lot of money, and it would cost us $95,000 for software and installation, and another $61,200 per year just to maintain the thing. In addition, the manufacturer admits it would cost $58,000 more at the end of three years to replace worn-out parts.” “I admit it’s a lot of money,” said Franci Rogers, the controller. “But you know the turnover problem we’ve had with the welding crew. This machine would replace six welders at a cost savings of $125,000 per year. And we would save another $8,600 per year in reduced material waste. When you figure that the automated welder would last for six years, I’m sure the return would be greater than our 16% required rate of return.” “I’m still not convinced,” countered Mr. Alder. “We can only get $22,500 scrap value out of our old welding equipment if we sell it now, and in six years the new machine…arrow_forwardA bicycle manufacturer currently produces 233,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $1.90 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.40 per chain. The necessary machinery would cost $224,000 and would be obsolete after ten years. This investment could be depreciated to zero for tax purposes using a ten-year straight-line depreciation schedule. The plant manager estimates that the operation would require $58,000 of inventory and other working capital upfront (year 0), but argues that this sum can be ignored since it is recoverable at the end of the ten years. Expected proceeds from scrapping the machinery after ten years are $16,800. If the company pays tax at a rate of 20% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the…arrow_forward
- "I'm not sure we should lay out $295,000 for that automated welding machine," said Jim Alder, president of the Superior Equipment Company. "It would cost us $83,000 for software and installation, and another $46,800 per year just to maintain. In addition, the manufacturer admits it would cost $46,000 more at the end of three years to replace worn-out parts." "I admit it's a lot of money," said Franci Rogers, the controller. "But you know the turnover problem we've had with the welding crew. This machine would replace six welders at a cost savings of $113,000 per year. And we would save another $7,400 per year in reduced material waste. When you figure the automated welder would last six years, I'm sure the return would be greater than our 19% required rate of return." "I'm still not convinced," countered Mr. Alder. "We can only get $16,500 scrap value for our old welding equipment if we sell it now, and in six years the new machine will only be worth $29,000 for parts." Click here to…arrow_forwardA bicycle manufacturer currently produces 237,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.20 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.60 per chain. The necessary machinery would cost $293,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposes using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require $44,000 of inventory and other working capital upfront (year 0), but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,975. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the…arrow_forward“I’m not sure we should lay out $235,000 for that automated welding machine,” said Jim Alder, president of the Superior Equipment Company. “That’s a lot of money, and it would cost us $76,000 for software and installation, and another $38,400 per year just to maintain the thing. In addition, the manufacturer admits it would cost $39,000 more at the end of three years to replace worn-out parts.” “I admit it’s a lot of money,” said Franci Rogers, the controller. “But you know the turnover problem we’ve had with the welding crew. This machine would replace six welders at a cost savings of $106,000 per year. And we would save another $6,700 per year in reduced material waste. When you figure that the automated welder would last for six years, I’m sure the return would be greater than our 15% required rate of return.” “I’m still not convinced,” countered Mr. Alder. “We can only get $13,000 scrap value out of our old welding equipment if we sell it now, and in six years the new machine will…arrow_forward
- At Stardust Gems, a faux gem and jewelry company, the setting department is a bottleneck. The company is considering hiring an extra worker, whose salary will be $67,000 per year, to ease the problem. Using the extra worker, the company will be able to produce and sell 9,000 more units per year. The selling price per unit is $20. The cost per unit currently is $15.85 as shown: What is the annual financial impact of hiring the extra worker for the bottleneck process?arrow_forwardA bicycle manufacturer currently produces 395,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $1.90 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.40 per chain. The necessary machinery would cost $231,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposes using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require $42,000 of inventory and other working capital upfront (year 0), but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $17,325. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the…arrow_forward“I’m not sure we should lay out $375,000 for that automated welding machine,” said Jim Alder, president of the Superior Equipment Company. “That’s a lot of money, and it would cost us $99,000 for software and installation, and another $66,000 per year just to maintain the thing. In addition, the manufacturer admits it would cost $62,000 more at the end of three years to replace worn-out parts.” “I admit it’s a lot of money,” said Franci Rogers, the controller. “But you know the turnover problem we’ve had with the welding crew. This machine would replace six welders at a cost savings of $129,000 per year. And we would save another $9,000 per year in reduced material waste. When you figure that the automated welder would last for six years, I’m sure the return would be greater than our 14% required rate of return.” “I’m still not convinced,” countered Mr. Alder. “We can only get $24,500 scrap value out of our old welding equipment if we sell it now, and in six years the new machine…arrow_forward
- Managerial Accounting: The Cornerstone of Busines...AccountingISBN:9781337115773Author:Maryanne M. Mowen, Don R. Hansen, Dan L. HeitgerPublisher:Cengage LearningPrinciples of Accounting Volume 2AccountingISBN:9781947172609Author:OpenStaxPublisher:OpenStax College