Clark Paints: The production department has been investigating possible ways to
ID: 2366995 • Letter: C
Question
Clark Paints: The production department has been investigating possible ways to trim total production costs. One possibility currently being examined is to make the paint cans instead of purchasing them. The equipment needed would cost $200,000, with a disposal value of $40,000, and it would be able to produce 5,500,000 cans over the life of the machinery. The production department estimates that approximately 1,100,000 cans would be needed for each of the next five years.The company would hire three new employees. These three individuals would be full-time employees working 2,000 hours per year and earning $12.00 per hour. They would also receive the same benefits as other production employees, 18% of wages, in addition to $2,500 of health benefits.
It is estimated that the raw materials will cost 25¢ per can and that other variable costs would be 5¢ per can. Since there is currently unused space in the factory, no additional fixed costs would be incurred if this proposal is accepted.
It is expected that cans would cost 45¢ each if purchased from the current supplier. The company's minimum rate of return (hurdle rate) has been determined to be 12% for all new projects, and the current tax rate of 35% is anticipated to remain unchanged. The pricing for a gallon of paint, as well as the number of units sold, will not be affected by this decision. The unit-of-production depreciation method would be used if the new equipment is purchased.
Required:
1. Based on the above information and using Excel, calculate the following items for this proposed equipment purchase:
o Annual cash flows over the expected life of the equipment
o Payback period
o Annual rate of return
o Net present value
o Internal rate of return
2. Would you recommend the acceptance of this proposal? Why or why not? Prepare a short double-spaced Word paper elaborating and supporting your answer.
Explanation / Answer
This function REQUIRES that you have only one cash flow per period (period 0 through period 5 for our example) This means that no annuity figures can be used. The chart for our example can be revised as follows: After Tax Item Year Amount Cost of machine 0 $ (200,000) Year 1 inflow 1 $ 58,351 Year 2 inflow 2 $ 58,351 Year 3 inflow 3 $ 58,351 Year 4 inflow 4 $ 58,351 Year 5 inflow 5 $ 98,351 The IRR function will require the range of cash flows beginning with the initial cash outflow for the investment and progressing through each year of the project. You also have to include an initial "guess" for the possible IRR. The formula is: =IRR(values,guess) IRR Function IRR(F78..F83,.30) 18.0% Under the net present value method, the present value of a project's cash inflows is compared to the present value of the project's cash outflows. The difference between the present values of these cash flows is called "the net present value". This net present value determines whether or not the project is an acceptable investment. According to this analysis, Clark Paints should purchase the new machine. The present value of the cost savings is $58,351, as compared to a present value of only $33,035 for the required investment (cost of the machine). Deducting the present value of the required investment from the present value of the cost savings leaves a net value of $25,316. Whenever the net present value is zero or greater, an investment project is acceptable. Whenever the net present value is negative an investment project is not acceptable. Clark Paints could spend up to $58,351 for the new machine and still obtain the minimum required rate of return. The net present value of $33,035, therefore, shows the amount of cushion. One way to look at this is that the company could underestimate the cost of the new machine by up to $33,035, or overestimate the net present value of the future cash savings by up to $33,035, and the project would still be financially attractive. Thus, looking at the data, since the machine has a positive NPV and the IRR is more than the cost of capital, I would recommend the acceptance of the proposal to purchase new equipment.