Clark Paints: The production department has been investigating possible ways to
ID: 2493887 • 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 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 5 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. Because 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 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
As the NPV of the proposal is positive the proposal should be accpeted.
Workings:
Year 0 1 2 3 4 5 Equipment cost (200,000) can Purchased from supplier 0.45 0.45 0.45 0.45 0.45 Raw material 0.25 0.25 0.25 0.25 0.25 other variable cost 0.05 0.05 0.05 0.05 0.05 Total variable cost 0.30 0.30 0.30 0.30 0.30 Contribution per can 0.15 0.15 0.15 0.15 0.15 1,100,000 1,100,000 1,100,000 1,100,000 1,100,000 Total contribution 165,000 165,000 165,000 165,000 165,000 Salaries 79,500 79,500 79,500 79,500 79,500 Depreciation 32,000 32,000 32,000 32,000 32,000 Profit before tax 53,500 53,500 53,500 53,500 53,500 Tax = 35% 18,725 18,725 18,725 18,725 18,725 Profit after tax 34,775 34,775 34,775 34,775 34,775 ADD: Depreciation 32,000 32,000 32,000 32,000 32,000 Cash flow 66,775 66,775 66,775 66,775 66,775 Disposal of Equipment 40,000 Total cashflow 66,775 66,775 66,775 66,775 106,775 Cummulative cashflow (200,000) (133,225) (66,450) 325 67,100 173,875 Discount factor 12% 1 0.8929 0.7972 0.7118 0.6355 0.5674 Discounted cash flow (200,000) 59,621 53,233 47,529 42,437 60,587 NPV(sum of the above cashflow) 63,406 Payback period in years 3 years 2+(66450/66775)