Cost The new opti-scanner machine would cost $75,000; shipping, installation, an
ID: 2741145 • Letter: C
Question
Cost The new opti-scanner machine would cost $75,000; shipping, installation, and testing would be an additional $20,000. It would cost $5,000 to dismantle the existing conveyer belt and prepare the area for the new system. To avoid disrupting production, management wanted to install the new systems—about a 16-hour process—over the next holiday weekend using existing maintenance personnel with technical staff from the manufacturer. The life expectancy of the opti-scanner was five years for capital investment purposes with a zero salvage value. The opti-scanner would probably incur an additional $1,200 per year in maintenance and insurance costs. With the machine, the company would not need the 4 inspectors employed on each of 2 shifts. These people worked 40 hours per week and received $10 per hour. The company assumed benefit costs of an extra 25%. The evening shift pay differential was an extra $0.50 per hour. Harold had informed the staff of the company’s policy to not terminate employees due to automation. Affected employees would be reassigned to other jobs within the company. However, Harold believed that these positions could be eliminated within 6 months through attrition and reductions in new hires, which would be a savings to the company. Inspectors tended to be the most recent hires. While the work can be monotonous, it was critical for ensuring product quality. The position experienced a higher turnover rate than other positions. The average employee stayed about 6 months to 1 year; then, 3 out of 4 transfer to other positions and 1 quits. It costs about $300 per employee in hiring and training. The inspector position also determined which employees proved capable of more skilled and technical positions. The company had only a limited number of entry-level positions of this nature, and these positions provided a natural training ground. To justify the acquisition to top management, the machine must give the company a payback of three years or less. Harold believed the labor savings and quality improvement would easily justify and give a satisfactory return on the investment. However, given the tight margins on all the product lines, a capital investment could impact cash flow, which may hurt the company’s credit rating and decrease its working capital. Since the company was privately held, top management probably needed to borrow money to finance this capital acquisition. Their long-standing association with the area banking community had allowed them to qualify for the lowest rate of 8.25% for this capital project. The company could also finance the equipment purchase from corporate earnings. Last year, company owners earned a rate of return of 14% on book equity. For planning purposes, Harold assumed that 80% of the opti-scanner would be funded by debt with the remaining funds coming from retained earnings. Their current corporate tax rate is 40%.
3. Evaluate this capital acquisition proposal and recommend a course of action.
Explanation / Answer
We need to find two things 1. Payback Period 2. NPV of Project
The company would make savings after installing the machine on personnel/inspectors. These benefits would accrue to the company after 6 months of installation.
Annual Savings = No. of Inspectors/shift (4) x Hours/Week/Inspector (40) x (1st shift hourly Charge (10) + 2nd shift hourly charge (10.5)) x No. of weeks (52)
For 1st year this will half as the benefits accrue after 6 months time.
Further the company would save extra 25% on benefits saved when these Inspector leave
Total Initial Investment Cost = 100000
1st year Net Income = 47280; 2nd year Net Income = 111240; Amount left to recover after 1st year = 10000-47280=52720
Payback Period = 1 + 52720/111240 = 1.47 (less than the threshold 3 years)
WACC = Weight of Debt x Cost of Debt x (1-Tax Rate) + Weight of Equity x Cost of Equity = 0.8 x 8.25% x (1-40%) + 0.2 x 14% = 6.76%
Cost of Equity has been taken as last years return on equity as the shareholders would like at least that much to be the return generated on their equity
To get the cashflow we add Net Income and depreciation expense because depreciation is non cash charge
Discounting the yearly cash flow using WACC we get the NPV of project
NPV = $ 381675.52
The investment is thus satisfies on both Payback period terms and NPV
Detailed calculations are shown in the table below:
1
100000/5=20000
(Total Investment/5)
1
Year 0 1 2 3 4 5 2 Machine Cost 75000 3 Shipping, Installation Cost 20000 4 Dismantalling Cost 5000 5 Total Initial Investment (2+3+4) 100000 6 Maintenance & Insurance Cost 1200 1200 1200 1200 1200 7 Depreciation Expense (Life5 Yrs, 0 Salvage Value)100000/5=20000
(Total Investment/5)
20000 20000 20000 20000 20000 8 No. of Inspectors/Shfit 4 9 Hours/Week/Person 40 10 Morning Shift/Hour Cost 10 11 Evening Shift/Hour Cost 10.5 12 No. of Weeks 52 13 Savings on Personnel 85280 170560 170560 170560 170560 14 Benefit Cost Saving 25% 21320 42640 42640 42640 42640 15 Debt (80%) 80000 16 Cost of Debt 8.25% 17 Debt Expense (15 x 16) 6600 6600 6600 6600 6600 18 Net Savings (13+14-6-7-17) 78800 185400 185400 185400 185400 19 Tax Rate 40% 20 Tax Expense (18 x 40%) 31520 74160 74160 74160 74160 21 Net Income (18-20) 47280 111240 111240 111240 111240 22 Payback Period 1.47 23 Cash Flow (21+7-5) -100000 67280 131240 131240 131240 131240 24 Cost of Equity (same as last yr. Return on equity) 14% 25 Cost Debt 8.25% 26 Weight of Debt 80% 27 Weight of Equity 20% 28 WACC 6.76% 29 NPV 381675.52