Question

In: Finance

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


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 newly-developed 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%.

Instructions:

- Read carefully

- Figure out each alternative

- This is one question.

Solutions

Expert Solution

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 becasue 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.


Related Solutions

Choose whether the following statements are true or false. The null and alternative hypotheses should be...
Choose whether the following statements are true or false. The null and alternative hypotheses should be written in terms of the sample statistic. TrueFalse The test statistic is computed assuming that the null hypothesis is true. TrueFalse The test statistic is usually equal to the sample statistic ?⎯⎯⎯⎯⎯ TrueFalse The p-value is the probability that the null hypothesis is true. TrueFalse 19. The p-value is the probability that the alternative hypothesis is true. TrueFalse If the p-value is smaller than...
What is a null hypothesis and what is an alternative hypothesis? How do you choose the...
What is a null hypothesis and what is an alternative hypothesis? How do you choose the null hypothesis in general? Give an example What is type I error? What is type II error? What is the significance level? What is the power of the test? What is the p-value of a hypothesis test?. Please type the answer as I have difficulties understanding handwritten answers. Thanks
what should be the relative position of complementary and alternative medicine? How should we determine what...
what should be the relative position of complementary and alternative medicine? How should we determine what gets paid for and why? Is there (or should there be) a clearinghouse for the efficacy of complementary and alternative medicine?
Which of the following payment options is the least costly choice available to a taxpayer who...
Which of the following payment options is the least costly choice available to a taxpayer who cannot pay the amount owed on the tax return by April 15, 2019 but who expects to pay it by August 1, 2019
Which of the following payment options is the least costly choice available to a taxpayer who...
Which of the following payment options is the least costly choice available to a taxpayer who cannot pay the amount owed on their tax return by April 17, 2018, but who expects to pay it by August 1,2018?
identify and discuss at least three (3) of the forces by which an organization would choose...
identify and discuss at least three (3) of the forces by which an organization would choose to adopt a front-back structure
What would persuade a company to choose capitalizing vs. expensing borrowing costs under ASPE? What would...
What would persuade a company to choose capitalizing vs. expensing borrowing costs under ASPE? What would persuade you the other way?
What is a null hypothesis and what is an alternative hypothesis?  How do you choose the null...
What is a null hypothesis and what is an alternative hypothesis?  How do you choose the null hypothesis in general? Give an example What is type I error? What is type II error? What is the significance level? What is the power of the test? What is the p-value of a hypothesis test?. Please type the answer. I have difficulties understanding handwritten answers. Thanks  
Suppose you think that at least 50% of children would choose chocolate chip as their favorite...
Suppose you think that at least 50% of children would choose chocolate chip as their favorite flavor of ice cream. But I find a survey of 100 children who were asked to identify their favorite flavor of ice cream, and 40 chose chocolate chip. I claim that a minority (in other words, less than 50%) of children actually prefer chocolate chip to any other flavor. (i) What are the null and alternate hypotheses? (ii) Find the test statistic. (iii) Use...
Choose at least two (2) specific transactions and determine the types of accounting methods that would...
Choose at least two (2) specific transactions and determine the types of accounting methods that would be available for your business. Recommend the method that would minimize the tax liabilities for the company. Provide support for your rationale.
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT