Question

Saxon Products, Inc., is investigating the purchase of a robot for use on the company’s assembly line. Selected data relating to the robot are provided below:

Cost of the robot	$	1,950,000
Installation and software	$	485,000
Annual savings in inventory carrying costs	$	217,000
Annual increase in power and maintenance costs	$	37,000
Salvage value in 5 years	$	77,000
Useful life		5	years

Engineering studies suggest that use of the robot will result in a savings of 32,000 direct labor-hours each year. The labor rate is $14 per hour. Also, the smoother work flow made possible by the use of automation will allow the company to reduce the amount of inventory on hand by $407,000. This inventory reduction will take place at the end of the first year of operation; the released funds will be available for use elsewhere in the company. Saxon Products has a 15% required rate of return.

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

Required:

1. Determine the annual net cost savings if the robot is purchased. (Do not include the $407,000 inventory reduction or the salvage value in this computation.)

2-a. Compute the net present value of the proposed investment in the robot.

2-b. Based on these data, would you recommend that the robot be purchased?

3-a. Assume that the robot is purchased. However, due to unforeseen problems, software and installation costs were $82,000 more than estimated and direct labor could only be reduced by 26,000 hours per year, rather than the original estimate of 32,000 hours. Assuming that all other cost data is accurate, what would a postaudit suggest is the actual net present value of this investment?

3-b. Does it appear that the company made a wise investment?

4-a. Which of the following are intangible benefits associated with the new automated equipment?

4-b. Based on your analysis in Requirement 3 above, compute for the president the minimum dollar amount of annual cash inflow that would be needed from the benefits in (a) above for the automated equipment to yield a 15% rate of return.

Answer 1

Solution

Saxon Products Inc

1. Determination of the annual net cost savings if the robot is purchased:

Savings in direct labor cost –

Annual savings in direct labor hours – 32,000

Rate per direct labor hour                   $14

Annual savings in direct labor cost    ($14 x 32,000)             $448,000

Annual savings in inventory carrying costs                           $217,000

Total annual cost savings                                                       $665,000

Less: Annual increase in power and maintenance costs        ($37,000)

Annual net cost savings if the robot is purchased                  $628,000

2.a Computation of the net present value of the proposed investment in the robot:

Net present value = present value of net savings in cost + present value of reduction in inventory at the end of first year – present value of net investment + present value of the salvage value

Given information –

Cost of the robot                                 $1,950,000

Add: installation and software           $485,000

Total initial cost of the robot              $2,435,000

Net annual cost savings                      $628,000 (calculated above)

Reduction in inventory                       $407,000

Useful life                                           5 years

Salvage value                                      $77,000

Discount rate                                      15%

Net Present Value (NPV) =

- initial investment (P/A, i%, n) + annual net cost savings (P/A, i%, n) + annual inventory reduction (P/A, i%, n) + salvage value (A/F, i%, n)

= - $2,435,000(P/F, 15%, 0) + $628,000 (P/A, 15%, 5) + $407,000 (P/F, 15%, 1) + $77,000 (A/F, 15%, 5)

= -$2,435,000 (1.000) + $628,000 (3.352) + $407,000 (0.8696) + $77,000 (0.1483)

            = - $2,435,000 + $2,105,056 + $353,927 +$11,419

            = $35,402

Hence, NPV = $35,402

The net present value of the proposed investment in robot at 15% rate of return is = $35,402

Note: 1. The cost of installation and software form part of the initial cost of the robot, as the cost is necessary to put the robot into use. Hence, the same is capitalized and forms part of the NPV calculation.

2. Reduction in the amount of inventory on hand at the end of first year of operation indicates release of cash locked in inventory and hence is a cash flow.

2b. The proposed investment in robot is positive, $35,402 the recommendation is to purchase the robot.

3a. Calculation of revised NPV:

Increase in software and installation costs                $82,000

Revised annual net cash flows, with reduction in direct labor hour savings:

Revised direct labor hour savings =26,000 per year

Reduced net annual cash flow = $14 x (32,000 -26,000) = $84,000

So, the initial investment increases by $82,000 and the annual net savings in cost reduce by $84,000.

Hence, the NPV for additional cost would be

= -$ 82,000 (P/F 15%, 0) + - $84,000 (P/A, 15% ,5)

-$75,000 (1.000) + -$84,000 (3.352) = -$82,000 -$281,568

            NPV                                        -$363,568

Less: Original NPV                            $35,402

NPV with revised cash flow data       -$328,166

Hence, the actual net present value of the investment is ($328,166).

3b. Considering, the negative NPV of $328,166, the company seems to have not taken a wise decision in opting to purchase the robot.

4a.Tangible benefits associated with the new automated equipment –

the tangible benefits associated with the new automated equipment are greater throughput, reduced inventories and high quality.