Specialty Steel Products (SSP) is considering replacing some of its machinery with a new flexible machining center (FMC) that will permit it to respond more quickly to changes in the marketplace. The price of the new equipment is $1.2 million. Base your analysis on the following data contained in SSP's capital authorization request:
A) Because the new system will boost output quality significantly, it is estimated that SSP's annual sale will rise somewhat, from its current level of $1.7 million to $2 million annually for the next five years. The before-tax and before-depreciation profit margin on SSP's sales, old and new, is estimated at 40%.
B) Working capital requirements are estimated to remain at 25% of sales.
C) The FMC will also cut overhead costs by $85,000 per year for the next five years.
D) The old machinery was purchased for $1 million three yeasr ago, and is being depreciated on a straight-line basis over its five year life. Its economic life as of today, however, is estimated to be five years. It can be sold for $300,000 today.
D) The FMC will be depreciated on a straight-line basis over its five-year life.
E) SSP faces a 40% corporate tax rate.
F) Given the relatively low risk of the revenue enhancement and cost savings, SSP estimates that the incremental cash flows generated by the FMC will have a cost of capital of only 12%, as compared to 14% for a typical company project. The risk-free interest rate is currently 8%.
G) SSP will receive and investment tax credit equal to 10% of the purchase price of the FMC.
H) The working capital will be recaptured at the end of fice years.
a. What is SSP's net investment required in the FMC? Assume that both pieces of equipment are being depreciated to a zero salvage value?
b. What are the operating cash flows for each of the next five years?
c. On the basis of the information supplied, should SSP replace its current equipment with the new system?
d. What questions might you raise about some of the assumptions implicit in SSP's capital authorization request?