Question

A manufacturer is considering alternatives regarding the production of highly specialized

and useful precision part, originally engineered and developed by the company, and

supplied to the company’s main customer. The company has patented the design and the

use of that particular component, so no-one else can produce it without the company’s

permission, and, therefore, it is one of the most profitable products that the firm sells,

providing $5M in annual revenues for the firm. Recently, however, the firm made certain

improvements to the alloy used in the production of the part, something the engineers

considered necessary to ensure the part meets new safety standards. Without certain

modifications, the existing equipment used in the production of the part in question would

not be able to handle the new alloy. In choosing how to address the problem, the company

has three alternatives. All alternatives will be able to use the new alloy, will result in the

same quality of finished produce, satisfying the company’s and its customer’s demands,

but differ in annual maintenance costs, initial price, and longevity.

The first alternative is to keep existing equipment, but update it to handle the new alloy.

The old equipment was bought three years ago, at the price of US$2.3M and is being

depreciated on the straight-line basis over 8-year useful life to its expected salvage value

of zero. In fact, the old equipment is already worthless on the market, because moving it

somewhere else costs as much as other firms are willing to pay for it. The necessary

updates, which need to be depreciated over 3 years, will not prolong the life of the

equipment, but will allow to increase the quality of finished product to the necessary level.

The expected cost of the necessary updates is $500K. The old equipment requires

$300,000 in annual maintenance expense.

The second alternative is to replace the old equipment with new one. The new equipment

would cost US$1.7M to buy and install, requires $500,000 in annual maintenance expense,

but has a useful life of 5 years. It is also depreciated using straight-line method but has a

salvage value of $200,000 at the end of its life.

The third alternative is to outsource the production of the part to an external contractor.

The management expected that external contractors would charge $800K per year to

produce the required quantity of the product, at the required quality, using the newlydeveloped

alloy.

What alternative would be the least costly for the company and what alternative should the

company choose? The company’s weighted average cost of capital is 10% and its marginal

rate of income tax is 21%.

- Use EXCEL to answer

Answer 1

Alternative 1: (numbers in thousands). Since the revenue is same in all the 3 cases, we need to do a cost analysis to find which alternative has the lowest cost in 5 years. Depreciation tax shield is calculated because depreciation saves taxes and hence reduces the cost. It is calculated as:

Depreciation in years 1 to 3: =((2300/8)+ (500/3))* 21%

The total cost in Atlernative 1 is $1.321 M

Year	Outflow	Depreciation Tax shield	Net Cost	DF @10%	PV of Outflow
0	-500	0	(500.00)	1	(500.00)
1	-300	95.375	(204.63)	0.909090909	(186.02)
2	-300	95.375	(204.63)	0.826446281	(169.11)
3	-300	95.375	(204.63)	0.751314801	(153.74)
4	-300	60.375	(239.63)	0.683013455	(163.67)
5	-300	60.375	(239.63)	0.620921323	(148.79)
					(1,321.33)

Alternative 2:

Year	Outflow	Depreciation Tax shield	Net Cost	DF @10%	PV of Outflow
0	-1700		(1,700.00)	1	(1,700.00)
1	-500	71.4	(428.60)	0.909090909	(389.64)
2	-500	71.4	(428.60)	0.826446281	(354.21)
3	-500	71.4	(428.60)	0.751314801	(322.01)
4	-500	71.4	(428.60)	0.683013455	(292.74)
5	-500	71.4	(428.60)	0.620921323	(266.13)
					(3,324.73)

The total cost is going to be $3.324 M in alternative 2. However, the salvage value at the end of 5 years of the machine will be $200k , so the PV will be $124k. ALso, the current machine will be discarded, that will lead to a capital loss and we will get tax benefit from that too. The value of old machine as of today is (2300/8)*5 = $1438

The tax shield on the capital loss= $1438 * 0.21 = $302k.

Hence the total cost in alternative 2 = $3324-124-302 = $2898k = $2.898M

Alternative 3:

Year	Outflow	DF @10%	PV of outflow
0	0	1	-
1	-800	0.909090909	(727.27)
2	-800	0.826446281	(661.16)
3	-800	0.751314801	(601.05)
4	-800	0.683013455	(546.41)
5	-800	0.620921323	(496.74)
			(3,032.63)

In addition , we will get a tax shield on capital loss by discarding the old equipment similar to previous sum= $302k

Hence, the net cost = $2.73M

Comparing all the 3 alternatives, we see that alternative 1 has the lowest cost. Hence it will generate maximum NPV.

Please reach out in comments section in case of any doubts