Question

Question 2

Mallette Manufacturing, Inc. produces washing machines, dryers, and dishwashers. Because of increasing competition, Mallette is considering investing in an automated manufacturing system. Since competition is most keen for dishwashers, the production process for this line has been selected for initial evaluation. The automated system for the dishwasher line 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 dishwashers per year. Sales and production 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
Direct 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, plus an estimated $20 million in software and implementation. 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, volume related overhead will be reduced by $4 per unit. Direct labor is reduced by 60 percent.

Other information:

•           if Mallette keeps the old system, sales will drop by 20,000 units to 80,000 units per year

•           the automated equipment could be sold for $4 million at the end of ten years. The software and implementation will have zero salvage value at any time after the implementation

•           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 tax rate is 40 percent.

•           the complete software and implementation costs are depreciated for tax purposes over 5 years on the straight-line basis.

•           the automated system will require an initial increase in working capital of $5,000,000 followed by another increase of $2,000,000 at the end of year 5.

•           the automated system cost of $54,000,000 will be depreciated on a straight line basis over 10 years

•           total annual fixed costs for the automated system will be $6,000,000

Required -

Do you recommend that Mallette purchase the automated system? Show detailed calculations.

Help please!

Thanks in advance

Answer 1

Year	Cash flow under Old system	Cash flow under Automated system	Difference in cash flows	PVIF@12%	Present value of difference
0	-300000	-59000000	-56000000	1	-56000000
1	3888000	7872000	3984000	0.892857	3557142.9
2	3888000	7872000	3984000	0.797194	3176020.4
3	3888000	7872000	3984000	0.71178	2835732.5
4	3888000	7872000	3984000	0.635518	2531904
5	3888000	5872000	1984000	0.567427	1125774.9
6	3888000	7872000	3984000	0.506631	2018418.4
7	3888000	7872000	3984000	0.452349	1802159.3
8	3888000	7872000	3984000	0.403883	1609070.8
9	3888000	7872000	3984000	0.36061	1436670.3
10	3648000	18872000	15224000	0.321973	4901720.6
Net Present value					-31005386
No, we do not recommend Mallette purchase the automated system as net present value of evaluation is negetive.

	Units sold		Sales		Direct materials	Direct Labor		Volume related overhead	Direct fixed overhead	Depreciation	Total Cost of production	Operating Income	Tax on operating Income	Operating Income after tax	Add : Depreciation as its non cash item	Total cash inflow
Old system		Per Unit	300		80	90		20	34	7.5	231.5	68.5	27.4	41.1	7.5	48.6
	80000	Total	24000000		6400000	7200000		1600000	2720000	600000	18520000	5480000	2192000	3288000	600000	3888000
Automated system	100000	Per Unit	300		60	36		16	60	54	226	74	29.6	44.4	54	98.4
		Total	30000000		6000000	3600000		1600000	6000000	5400000	22600000	5920000	2368000	3552000	4320000	7872000