Question

Your company has been approached by Detroit Motors to bid on supplying Detroit Motors with 61,500 tons of machine screws annually for five years. You will need an initial $1,880,000 to purchase threading equipment to get the project started. The accounting department estimates that the variable costs of production will be $250 per ton and that additional annual fixed costs of $575,000 will be required for the project.

For tax purposes you have a choice of either Straight-line (SL) or Modified Accelerated Cost Recovery System (MACRS) depreciation to a zero residual value over five years. However, you expect to be able to sell the used threading equipment for $220,000, net of dismantling costs, at the end of the fifth year. MACRS percentages for an asset with a five-year life are 20%, 32%, 19%, 11%, 10%, and 5%.

Given an applicable income tax rate of 40% (for all years) and an MARR (cost of capital or hurdle rate) of 16%, determine the lowest per ton selling price that you could offer to Detroit Motors so that you would meet your MARR requirements (and, possibly, outbid the competition).

Required:

a. In determining your lowest possible per ton selling price, which method of depreciation, SL or
MACRS, would you choose and WHY?

b. Regardless of your answer to part a, assume that you were to choose Straight-line depreciation for the threading equipment. Determine the lowest per ton bid price that will meet your
MARR requirements?

Answer 1

A. Selling Price determined using MACRS depreciation.

376000			Selling Price per Unit	413.61
			Tons of screws	61500
			Variable Cost Per Unit	250
1880000	-220000	1660000
376000		YEAR	YEAR	YEAR	YEAR	YEAR	YEAR
		0	1	2	3	4	5
TOTAL SELLING PRICE	(413.61x61500)		$25,437,015.0	$25,437,015.0	$25,437,015.0	$25,437,015.0	$25,657,015.0
FIXED COST		-$1,880,000.0	-$575,000.0	-$575,000.0	-$575,000.0	-$575,000.0	-$575,000.0
VARIABLE COST			-$15,375,000.0	-$15,375,000.0	-$15,375,000.0	-$15,375,000.0	-$15,375,000.0
	MACRS	0.2	$376,000.0	$300,800.0	$240,640.0	$192,512.0	$154,009.60	$396,038.4
	MACRS	0.32	$601,600.0	$409,088.0	$278,179.8	$189,162.3	$128,630.36	$53,339.5
	MACRS	0.19	$357,200.0	$289,332.0	$234,358.9	$189,830.7	$153,762.89	$435,515.5
	MACRS	0.11	$206,800.0	$184,052.0	$163,806.3	$145,787.6	$129,750.95	$829,803.2
	MACRS	0.1	$188,000.0	$169,200.0	$152,280.0	$137,052.0	$123,346.80	$890,121.2
	MACRS	0.05	$94,000.0	$89,300.0	$84,835.0	$80,593.3	$76,563.59	$1,234,708.2
TOTAL INCOME		-$1,880,000.0	$8,885,415.0	$9,077,927.0	$9,208,835.2	$9,297,852.7	$9,578,384.6
AFTER TAX NET INCOME (60% of TOTAL INCOME)			5331249.00	5446756.20	5525301.10	5578711.63	5747030.79
DISCOUNT RATE			0.16	0.16	0.16	0.16	0.16
NET PRESENT VALUE			$4,595,904.3	$4,047,827.1	$3,539,826.5	$3,081,072.8	$2,736,236.2	$18,000,866.9

Selling price using SLM method:

376000			Selling Price per Unit	413.25
			Tons of screws	61500
			Variable Cost Per Unit	250
1880000	-220000	1660000
376000		YEAR	YEAR	YEAR	YEAR	YEAR	YEAR
		0	1	2	3	4	5
TOTAL SELLING PRICE	(413.25x61500)		$25,414,875.0	$25,414,875.0	$25,414,875.0	$25,414,875.0	$25,634,875.0
FIXED COST		-$1,880,000.0	-$575,000.0	-$575,000.0	-$575,000.0	-$575,000.0	-$575,000.0
VARIABLE COST			-$15,375,000.0	-$15,375,000.0	-$15,375,000.0	-$15,375,000.0	-$15,375,000.0
	MACRS	0.2	$376,000.0	$300,800.0	$240,640.0	$192,512.0	$154,009.60	$396,038.4
	MACRS	0.32	$332,000.0	$332,000.0	$332,000.0	$332,000.0	$332,000.0	$0.0
	MACRS	0.19	$357,200.0	$289,332.0	$234,358.9	$189,830.7	$153,762.89	$435,515.5
	MACRS	0.11	$206,800.0	$184,052.0	$163,806.3	$145,787.6	$129,750.95	$829,803.2
	MACRS	0.1	$188,000.0	$169,200.0	$152,280.0	$137,052.0	$123,346.80	$890,121.2
	MACRS	0.05	$94,000.0	$89,300.0	$84,835.0	$80,593.3	$76,563.59	$1,234,708.2
TOTAL INCOME		-$1,880,000.0	$9,132,875.0	$9,132,875.0	$9,132,875.0	$9,132,875.0	$9,352,875.0
AFTER TAX NET INCOME (60% of TOTAL INCOME)			5479725.00	5479725.00	5479725.00	5479725.00	5611725.00
DISCOUNT RATE			0.16	0.16	0.16	0.16	0.16
NET PRESENT VALUE			$4,723,900.9	$4,072,328.3	$3,510,627.9	$3,026,403.3	$2,671,815.3	$18,005,075.7

We can see that per ton selling price using SLM method is coming to $413.25, so using SLM is better.