“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
- 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_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_forwardThe management of Kimco is evaluating the possibility of replacing their large mainframe computer with a modern network system that requires much less office space. The network would cost $760,000 (including installation costs) and would save $150,000 per year in net cash flows (accounting for taxes and depreciation) in Year 1-2, $160,000 in year3-4, and $120,000 in year 5 due to efficiency gains. The current mainframe has a remaining book value of $160,000 and would be immediately sold for $120,000. Kimco’s discount rate is 10%, and its tax rate is 25%. Based on NPV, should management install the network system?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 $5.25 less than it costs us to manufacture the drums in our own plant. Because we use 95,000 drums a year, that equals an annual cost savings of $498,750.” Antilles Refining’s current cost to manufacture one drum is given below (based on 95,000 drums per year): Direct materials $ 10.60 Direct labor 6.50 Variable overhead 1.50 Fixed overhead ($3.90 general company overhead, $1.55 depreciation, and $1.20 supervision) 6.65 Total cost per drum $ 25.25 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: Alternative 1: Rent new equipment and continue to make the drums. The equipment would be rented for $342,000 per…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_forwardYou are a manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. Your boss comes into your office, drops a consultant’s report on your desk, and complains, "We owe these consultants $1 million for this report, and I am not sure their analysis makes sense. Before we spend the $25 million on the new equipment needed for this project, look it over and give me your opinion." You open the report and find the following estimates (in thousands of dollars) for the project: Project year 1 2 … 9 10 Sales revenue 30,000 30,000 30,000 30,000 - Cost of goods sold 18,000 18,000 18,000 18,000 =Gross profit 12,000 12,000 12,000 12,000 - Gen, sales and admin expenses 2,000 2,000 2,000 2,000 - Depreciation 2,500 2,500 2,500 2,500 =Net operating income 7,500 7,500 7,500 7,500 - Income tax 2,625 2,625 2,625 2,625 =Net Income…arrow_forward
- Imagine you are the manager of operations for a manufacturing company. Your vice president wants to expand production by building a new facility, and she would like you to develop a business case for the project. Assume that your company’s weighted average cost of capital is 13%, the after-tax cost of debt is 7%, preferred stock is 10.5%, and common equity is 15%. As you work on the business case, you surmise that this is a fairly risky project because of a recent slowing in product sales. In fact, when using the 13% weighted average cost of capital, you discover that the project is estimated to return about 10%, which is quite a bit less than the company’s weighted average cost of capital. Your vice president suggests that the project could be financed from a mix of retained earnings (50%) and bonds (50%). She reasons that retained earnings do not cost the company anything because it is cash you already have and the after-tax cost of debt is only 7%. That would lower your weighted…arrow_forwardYou are working for Toyota and trying to determine how many of their newest model of electric vehicle they will need to sell to break even. These cars will sell for $55,000 a piece. To manufacture this model, you will need to purchase a new production facility that will cost $150,000,000. The cost of materials for a single EV is $21,000, and the cost of labor is $8,000. How many of these cars will Toyota need to sell to breakeven?arrow_forwardImagine you are the manager of operations for a manufacturing company. Your vice president wants to expand production by building a new facility, and she would like you to develop a business case for the project. Assume that your company’s weighted average cost of capital is 13%, the after-tax cost of debt is 7%, preferred stock is 10.5%, and common equity is 15%. As you work on the business case, you surmise that this is a fairly risky project because of a recent slowing in product sales. In fact, when using the 13% weighted average cost of capital, you discover that the project is estimated to return about 10%, which is quite a bit less than the company’s weighted average cost of capital. Your vice president suggests that the project could be financed from a mix of retained earnings (50%) and bonds (50%). She reasons that retained earnings do not cost the company anything because it is cash you already have and the after-tax cost of debt is only 7%. That would lower your weighted…arrow_forward
- You are a manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. Your boss comes into your office, drops a consultant's report on your desk, and complains, "We owe these consultants $1.3 million for this report, and I am not sure their analysis makes sense. Before we spend the $22 million on new equipment needed for this project, look it over and give me your opinion." You open the report and find the following estimates (in millions of dollars): All of the estimates in the report seem correct. You note that the consultants used straight-line depreciation for the new equipment that will be purchased today (year 0), which is what the accounting department recommended. The report concludes that because the project will increase earnings by $5.472 million per year for ten years, the project is worth $54.72 million. You think back to your halcyon days in finance class and realize there is more work to be done! First,…arrow_forwardThe president believes it would be a mistake to change the unit selling price. Instead, he wants to use less costly raw materials, thereby reducing unit cost by 70 cents. How many units would have to be sold next year to earn target profit of $30,200?arrow_forwardYou are a manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. Your boss comes into your office, drops a consultant's report on your desk, and complains, "We owe these consultants $1.3 million for this report, and I am not sure their analysis makes sense. Before we spend the $22 million on new equipment needed for this project, look it over and give me your opinion." You open the report and find the following estimates (in millions of dollars): All of the estimates in the report seem correct. You note that the consultants used straight-line depreciation for the new equipment that will be purchased today (year 0), which is what the accounting department recommended. The report concludes that because the project will increase earnings by $5.472 million per year for ten years, the project is worth $54.72 million. You think back to your halcyon days in finance class and realize there is more work to be done! First,…arrow_forward
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