Question: A manufacturer of packaging for companies that produce breakfast cereals is considering alternatives regarding the process it uses to pre-process carton paper used to make the packaging. Historically, the company has been using equipment which cuts raw carton paper received from its various suppliers. This cut paper is further painted and assembled into a box shape by two other pieces of equipment.
Recently, however, most of its customers began requesting that certain design elements be pressed into the packaging, giving the packaging more visual appeal. The customers were willing to pay more for the added service, making it particularly lucrative for the firm to have incorporate this possibility into its packaging offerings.
Managers believed that the existing equipment would be able to handle the new process with certain modifications. In addition to modifying the existing equipment, the company two other alternatives. All alternatives will be able to produce the desired result, will result in the same quality of finished produce, satisfying the company's and its customer's demands, but differ in annual maintenance costs, initial price, and longevity.
The first alternative is to keep existing equipment, but update it to handle the new process. The old equipment was bought three years ago, at the price of US$4M and is being depreciated on the straight-line basis over 8-year useful life to its expected salvage value of zero. Managers determined that the old equipment's current market value is $1.5M, which is below its book value due to significant expenses associated with moving it somewhere else. The necessary updates, which need to be depreciated over 4 years, will allow to provide the modifications that customers were seeking. The expected cost of the necessary updates is $1100K. The old equipment requires $500,000 in annual maintenance expense.
The second alternative is to replace the old equipment with new one. The new equipment would cost US$2M to buy and install, requires $800,000 in annual maintenance expense, but has a useful life of 6 years. It is also depreciated using straight-line method but has a salvage value of $200,000 at the end of its life.
The third alternative is to outsource the cutting of the paper to an external contractor. This will involve selling the existing equipment. The management expected that external contractors would charge $1.5M per year to produce the required quantity of pre-cut carton paper, at the required quality, using the new process with pressed elements. The added benefit of the outsourcing is that it will allow to reduce days of sales in inventories by 3 days, or roughly $300K, due to buying the paper later in the production process.
What alternative would be the least costly for the company and what alternative should the company choose? The company's weighted average cost of capital is 10% and its marginal rate of income tax is 35%.