Paper Solutions Ltd manufactures three different models of paper shredders including the waste container that serves as the base. While the shredder heads are different for the three models, the waste container used in the three models is identical. The number of waste containers that Paper Solution will need during the next five years is estimated as follows:
Year 1 ……………………………………………..50 000
Year 2 ……………………………………………..50 000
Year 3 ……………………………………………..52 000
Year 4 ……………………………………………..55 000
Year 4 ……………………………………………..55 000
The equipment used to manufacture the waste container must be replaced because it has broken-down and cannot be repaired. Management is considering the purchase of robotic equipment to replace the old machinery. The new equipment would have a purchase price of $945 000. There will be a 2 percent discount if payment is made within 10 days, Company policy is to take all purchase discounts. The freight on the equipment would be $11 000, and installation costs would total $22 900. Freight and installation costs will be included as part of the equipment’s acquisition cost for taxation depreciation purposes. The equipment would be purchased and placed into service on 1 January year 1. It would have a five-year useful life and would be depreciated for tax purposes at 33 percent per annum using the straight-line method. This equipment is expected to have of $12 000 at the end of its useful life in Year 5, which is relevant for accounting depreciation but not for taxation depreciation. The new equipment would result in a 25 percent reduction in both direct labour and variable overhead. There will be an additional one-off permanent decrease in working capital requirement of $2 500, resulting from a reduction in direct material inventories. This working capital reduction would be recognised in the analysis at the time of equipment acquisition. The old equipment is fully depreciated, and it can be sold for $1 500.
Rather than replace the equipment, one of Paper Solutions production managers has suggested that the waste containers be purchased. The company has no alternative use for the manufacturing space at this time, so if the waste containers were purchased, the old equipment would be left in place. One supplier has quoted a price of $27 per container. This price is $8 less than the company’s current manufacturing cost, which is as follows:
Paper Solutions uses a plant wide fixed overhead rate in its operations. If the waste containers are purchased outside, the salary and on-costs of one supervisor, included in the fixed overhead budget at $90 000, would be eliminated. There would be no further changes in the other cash and non-cash items included in fixed overhead, except depreciation on the new equipment. The company income tax rate is 40 percent. Management assumes that all annual cash flows and tax payments occur at the end of the year, and uses a 12 percent after-tax discount rate.
Required:
Paper solutions must decide whether to purchase the waste containers from an outside supplier or to purchase the equipment to manufacture the waste containers.
(a) Calculate the of the estimated after-tax cash flows.
(b) Calculate the internal rate of return.
(c) Calculate the for the new equipment.
2 Use your results in requirement 1 to recommend which of the two options to undertake.
3 Explain why some companies calculate the of an investment in addition to determining the or IPP.
4 Outline the strategic or other qualitative considerations that may need to be taken into account that relate to the two alternative courses of action.
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