Cost The new opti-scanner machine would cost $75,000; shipping, installation, an
ID: 2741346 • 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.( please explain in detail how to find NPV and Pay back period... need help :)
Explanation / Answer
Captial Aquistion decisions based on Pay back period method: (workings in Dollars)
COST OF MACHINERY:
Opti Scanner cost 75000
Shipping, installation and testing 20000
Dismanting of existing conveyor belt 5000
Total cost of the machinery 100000
Funding required for the capital investment could be met through 80% Bank loan and balnace through retained earnings
CACLULATION OF PAY BACK PERIOD:
YEARS
1 2 3 4 5
Total Employee Cost savings - (Ref Note1) 49200 49200 49200 49200 49200
Less: Additional cost for maintenance (1200) (1200) (1200) (1200) (1200)
Less: Additional cost of hiring (Refer Note 2) (600) (600) (600) (600) (600)
Less: Interest cost (Refer Note 3) (6600) (5280) (3960) (2640) (1320)
Net Cash flows 40800 42120 43440 44760 46080
Less: Corporate tax rate @ 40% (16320) (16848) (17376) (17904) (18432)
Net savings after taxes 24480 25272 26064 26856 27648
Cumulative cash flows 24480 49752 75816 102672 130320
Pay back period 1 2 3 10 months
in 3 years 10 months company is recovering the investment cost
NET PRESENT VALUE:
Cost of capital of the company is 14% and PV factors for 14%
YEARS
0 1 2 3 4 5 Total
PV Factor 1 0.88 0.77 0.67 0.59 0.52
Initial investment (100000) - - - - -
Net savings after taxes 24480 25272 26064 26856 27648 130320
Present value of cash flows 21474 19446 17592 15901 14360 88773
As per the present values it is coming to neative by 11227 and where as the company is not earning to the extent of return on captital and atleast to meet the cost of capital, keeping in view the remaining options available to earn the rate of return of 14% if any option gives more beneficial then opt otherwise this option is econonical.
Workings
Note 1
Savings in Salaries of 4 inspectors each in two shifts 1 2 3 4 5
Day Shit - 40*4weeks*12months @ 10$ per hour 19200 19200 19200 19200 19200
Night Shit - 40*4weeks*12months @ 10.5$ per hour 20160 20160 20160 20160 20160
Benefit costs of extra 25% 9840 9840 9840 9840 9840
Total Employee Cost savings 49200 49200 49200 49200 49200
Note 2
Additional cost of hiring
Employees leaving in every 6 months to 1 year, mentioned in 4 out 3 transferred 1 quit, on an average 2 empolyees leaving every year, requires training for 2 employees costs 300$ each
Note3
Company has in long term association with the bankers and appraoching for 80% of funds requirement @ 8.25% per annum for this capital projects, as the life of the project is 5 years, presuming that the company repays the loan in 5 years with equal instalments
Year Loan Interest Repayment Balance
1 80000 6600 16000 64000
2 64000 5280 16000 48000
3 48000 3960 16000 32000
4 32000 2640 16000 16000
5 16000 1320 16000 0