1. Wisconsin Products Company manufactures several different products. One of the firm's principal products sells for $20 per unit. The sales manager of Wisconsin Products has stated repeatedly that he could sell more units of this product if they were available. In an attempt to substantiate his claim, the sales manager conducted a market research study last year at a cost of $44,000 to determine potential demand for this product. The study indicated that Wisconsin Products could sell 18,000 units of this product annually for the next five years.
The equipment currently in use has the capacity to produce 11,000 units annually. The variable production costs are $9 per unit. The equipment has a book value of $60,000 and a remaining useful life of five years. The salvage value of the equipment is negligible now and will be zero in five years. A maximum of 20,000 units could be produced annually on the new machinery which can be purchased. The new equipment costs $300,000 and has an estimated useful life of five years with no salvage value at the end of five years. Wisconsin Products' production manager has estimated that the new equipment would provide increased production efficiencies that would reduce the variable production costs to $7 per unit. Wisconsin Products Company uses straight-line depreciation on all of its equipment for tax purposes. The firm is subject to a 40 percent tax rate, and its after-tax cost of capital is 15 percent. The sales manager felt so strongly about the need for additional capacity that he attempted to prepare an economic justification for the equipment, although this was not one of his responsibilities. His analysis, presented below, disappointed him because it did not justify acquiring the equipment.
|
Required Investment
|
|
Purchase price of new equipment
|
|
$300,000
|
|
Disposal of existing equipment:
|
|
|
|
Loss of disposal
|
$60,000
|
|
|
Less: Tax benefit (40%)
|
24,000
|
36,000
|
|
Cost of market research study
|
|
44,000
|
|
Total investment
|
|
$380,000
|
|
Annual Returns
|
|
Contribution margin from product:
|
|
|
|
Using the new equipment [18,000 X ($20 -$7)]
|
$234,000
|
|
|
Using the existing equipment [11,000 X ($20 -$9)]
|
121,000
|
|
|
Increase in contribution margin
|
$1 13,000
|
|
|
Less: Depreciation
|
60,000
|
|
|
Increase in before-tax income
|
$ 53,000
|
|
|
Income tax (40%)
|
21,200
|
|
|
Increase in income
|
$ 31,800
|
|
|
Less: 15% cost of capital on the additional
|
|
|
|
investment required (0.15 X $380,000)
|
57,000
|
|
|
Net annual return of proposed investment in new equipment
|
$ (25,200)
|
|
1. The controller of Wisconsin Products Company plans to prepare a discounted cash flow analysis for this investment proposal. The controller has asked you to prepare corrected calculations of
(a) The required investment in the new equipment
(b) The recurring annual cash flows
Explain the treatment of each item of your corrected calculations that is treated differently from the original analysis prepared by the sales manager.
2. Calculate the net present value of the proposed investment in the new equipment.