East Side, Inc.
The management of East Side, Inc. is preparing its capital budget for 2015. East side has two divisions. One runs a restaurant (the Restaurant Division). The other brews beer (the Brewery Division). Most of the analysis for 2015 projects has been completed, but some refinements are needed in the analysis of one more project.
This project is one that is expected to have no impact on sales revenue, but reduce costs in the Brewery Division. The capital investment for equipment required for the project in question is $200,000. Setup costs associated with the new equipment are expected to add another 15 percent to the initial investment amount. Management believes that the investment and expenses associated with buying and setting up the equipment will be depreciated using straight-line method. The equipment is expected to have a five-year operating life. At the end of that period, the machinery is expected to be sold for $15,000.
Management expects the total projected sales revenue in the Brewery division in 2015 to be $1,000,000 and revenues are expected to grow by 5 percent per year for the next four years due to inflation.
The expected benefits of the new equipment are twofold. First, management expects to reduce direct labor costs by a total of 8% of total sales revenue each year for five years. Second, management believes that the new machine will reduce hops used in the manufacturing process by 2000 pounds per year. Each pound of hops costs $5. The nominal price per pound is not expected to change.
The new machinery is very sensitive to the intensity with which it will be used and might require extensive annual maintenance. Management is not exactly sure how to estimate the maintenance expenses, but is sure that whatever they are, they will be treated as a tax-deductible expense in the period in which they are incurred.
After careful discussion with the equipment vendor, management has concluded that there is a 20 percent probability that the machine will be used so extensively every year during its five-year life that it will require the maximum maintenance. The cost of the maximum maintenance will be $50,000 per year before tax. There is a 50 percent chance that its usage will result in a $30,000 annual maintenance expense. Further, management believes that there is a 30 percent chance that it will be used in such a way that annual maintenance expenses will be only $10,000. The nominal cost of maintenance is not expected to change.
The CFO has indicated that regardless of the source of financing used, the nominal after tax cost of capital for all projects considered by the brewery is 15% for the foreseeable future. Also, a tax rate of 35 percent should be used in all analyses.
Questions:
A. Should the company invest in the labor saving equipment?
B. Suppose now that in addition to labor savings and quality improvements, management believes that the new equipment will enhance working capital productivity. Specifically, management projects that the firm’s required investment in work-in-progress inventory will decline from 20 percent of sales to 15 percent of sales. How, if at all, does this change your answer to question A?