Question

The Brisbane Manufacturing Company produces a single model of a CD player. Each player is sold for $192 with a resulting contribution margin of $70. Brisbane's management is considering a change in its quality control system. Currently, Brisbane spends $41,000 a year to inspect the CD players. An average of 2,000 units turn out to be defective - 1,600 of them are detected in the inspection process and are repaired for $85. If a defective CD player is not identified in the inspection process, the customer who receives it is given a full refund of the purchase price. The proposed quality control system involves the purchase of an x-ray machine for $190,000. The machine would last for five years and would have salvage value at that time of $18,000. Brisbane would also spend $580,000 immediately to train workers to better detect and repair defective units. Annual inspection costs would increase by $22,000. This new control system would reduce the number of defective units to 380 per year. 310 of these defective units would be detected and repaired at a cost of $47 per unit. Customers who still received defective players would be given a refund equal to 150% of the purchase price.

1. What is the Year 2 cash flow if Brisbane keeps using its current system?

2. What is the Year 2 cash flow if Brisbane replaces its current system?

3. Assuming a discount rate of 6%, what is the net present value if Brisbane keeps using its current system?

4. Assuming a discount rate of 6%, what is the net present value if Brisbane replaces its current system?

Answer 1

1. Year 2 cash flow if the Brisbane keeps using its current system will be as follows :-

$41000 (annual inspection exp.) +1600x$85 (repairment cost)+400x$192 (refund cost) = $253800.

2. Year 2 cash flow if the Brisbane replaces its current system will be as follows :-

$63000 (annual inspection exp.) + 310x$47 (repairing exp.) + 70x$288 (refund cost) = $97730.

3. NPV if brisbane continue using its current system for 5 years will be as follows :-

$253800xpvaf(5,6%)

=$253800x4.21

=$1068498

Thus, net present value of cash outflow in case brisbane continues with its existing system is $1068498.

4. net present value in case brisbane replaces its current system will be calculated as follows :-

present value of initial outflow = $190000 (X ray machine) + $580000 (training cost)

=$770000

present value of terminal inflow = 18000xpvif(5,6%)

= $18000x0.7473

= $13451

present value of annual exp. = $97730xpvaf(5,6%)

= $97730x4.21

= $411443

net present value of cash outflow in case brisbane replaces its current system = $770000+$411443-$13451

= $1167992.