Question

Mallette Manufacturing, Inc. produces professional styling blow dryers for salons. Because of increasing competition, Mallette is considering investing in an automated manufacturing system. The automated system would replace an existing system (purchased one year ago for $6 million). Although the existing system will be fully depreciated in nine years, it is expected to last another ten years. The automated system would also have a useful life of ten years. The existing system is capable of producing 100,000 units per year. Data using the existing system are provided by the Accounting Department: Sales per year (units) 100,000 Selling price $300 Costs per unit: Direct materials 80 Direct labor 90 Variable overhead 20 Fixed overhead* 40 * All cash expenses with the exception of depreciation, which is $6 per unit. The existing equipment is being depreciated using the straight-line method with no salvage value considered. The automated system will cost $34 million to purchase. If the automated equipment is purchased, the old equipment can be sold for $3 million. The automated system will require fewer parts for production and will produce with less waste. Because of this, the direct materials cost per unit will be reduced by 25 percent. Automation will also require fewer support activities, and, as a consequence, variable overhead will be reduced by $4 per unit. Direct labor is reduced by 60 percent. Currently, Mallete produces and sells 80,000 units annually. Other information: • the automated equipment could be sold for $4 million at the end of ten years. • the equipment of the old system would have no salvage value at the end of ten years. • the firm's cost of capital is 12 percent. • the automated system will require an increase in working capital of $5,000,000. • the automated system cost of $34,000,000 will be depreciated for accounting purposes on a straight line basis over 10 years • total annual fixed costs for the automated system will be $4,000,000 (including depreciation) Required Do you recommend that Mallette purchase the automated system. Show detailed calculations.  

Answer 1

We can make the decision by using Incremental NPV Method :

Computation of Incremental Depreciation:

Depreciation of Old Machine per annum = 6000000/10=600,000

Depreciation of New Machine per Annum =(34000000-4000000)/10=30000000/10=3,000,000

Incremental Depreciation=3000000-600000=2400000 per annum

Computation of Incrememtal Contribution:

Particulars	Existing	New
Sale price	300	300
- Direct Material	-80	=(80-25%)=-60
- Direct Labour	-90	=(90-60%)=-36
- Variable Cost	-20	-16
- Other cash expenses	-6	-6
Contribution	104	182

* Fixed Overheads are sunk cost and hence not included for decision making.

Incremental Contribution =182-104=78per unit

Annual Sales = 80000 units

Therefore Incremental Contribution = 80000*78=6240000 per annnum

Computation of Incremental cashoutflows

New machine cost =34 million

- sale of old machine =3 million

+Working Capital =5 million

Net Outflow =36 million

Computation of Terminal Cash flow at end of 10 years

Sale of New machine= 4 million

inflow of working capital = 5 million

total = 9million

Increase in Fixed costs for new machine = 4million

this includes depreciation of 3 million

therefore net increase in fixed cost = 1 million

Computation of Incremental NPV :

Net Annual Inflow = 6240000-1000000=5240000

present value of Annual Inflows for 10 years=5240000* PVAF (12%,10years)

=5240000*5.6502 = 29607048

present value of terminal Inflows= 9000000*0.322=2898000

Incremental NPV =29607048+2898000-36000000=-3494952

since the Incremental NPV is negitive it is not viable to but new machine

Assumptions

it is assumed that the sale price is same at 80000 production level and same even in case of new machine.