The Xerox DocuColor iGen3 digital production press is a high- volume, on- demand, full- color printer capable of producing up to 6,000 impressions (pages) per hour. It weighs nearly 3 tons, stretches 30 feet long, and holds more than 40 pounds of dry ink. It sells for over $ 500,000, and its principal market is print shops that produce mail order catalogs (e. g., L. L. Bean). Xerox offers two leasing options for the iGen3. Option A requires a three- year agreement with a monthly lease fee of $ 10,000 plus $ 0.01 per impression. Option B (also a three- year agreement) does not include a monthly lease fee but requires a charge of $ 0.03 per impression. ColorGrafix is a print shop considering leasing the iGen3 to begin producing customized mail-order catalogs. Besides leasing the iGen3, ColorGrafix estimates that it will have to buy ink for the iGen3 at a cost of $ 0.02 per impression and hire an operator to run the iGen3 to produce the customized catalogs at a cost of $ 5,000 per month. ColorGrafix estimates that it can charge $ 0.08 per impression for customized color catalogs. Required: a. If ColorGrafix leases the iGen3 and chooses Option A, how many impressions per month will ColorGrafix have to sell and produce to break even? b. If ColorGrafix leases the iGen3 and chooses Option B, how many impressions per month will ColorGrafix have to sell and produce to break even? c. Should ColorGrafix choose Option A or Option B? Explain why. d. ColorGrafix is a fairly new firm (only three years old) and has a substantial amount of debt that was used to help start the company. ColorGrafix has positive net cash flow after servicing the debt, but the owners of ColorGrafix have not felt it wise to withdraw any cash from the business since its inception, except for their salaries. ColorGrafix expects to sell and produce 520,000 impressions per month. Which lease option would you recommend ColorGrafix choose? Explain why. SOLUTIO a and b. Breakeven number of impressions under Options A and B: Option A Option B Monthly fixed lease cost $10,000 $0 Labor/month 5,000 5,000 Total fixed cost/month $15,000 $5,000 Variable lease cost/impression $0.01 $0.03 Ink/impression 0.02 0.02 Total variable cost $0.03 $0.05 Price/impression $0.08 $0.08 Contribution margin/impression $0.05 $0.03 Breakeven number of impressions 300,000 166,667 c. The choice of Option A or B depends on the expected print volume ColorGrafix forecasts. Choosing among different cost structures should not be based on breakeven but rather which one results in lower total cost. Notice the two options result in equal cost at 500,000 impressions: $15,000 + $0.03 Q = $5,000 + $0.05 Q $10,000 = $0.02 Q = 500,000 Therefore, if ColorGrafix expects to produce more than 500,000 impressions it should choose Option A and if fewer than 500,000 impressions are expected ColorGrafix should choose Option B. d. At 520,000 expected impressions, Option A costs $30,600 ($15,000 + .03 × 520,000), whereas Option B costs $31,000 ($5,000 + .05 × 520,000). Therefore, Option A costs $400 less than Option B. However, Option A generates much more operating leverage ($10,000/month), thereby increasing the expected costs of financial distress (and bankruptcy). Since ColorGrafix has substantial financial leverage, they should at least consider if it is worth spending an additional $400 per month and choose Option B to reduce the total amount of leverage (operating and financial) in the firm. Without knowing precisely the magnitude of the costs of financial distress, one can not say definitively if the $400 additional cost of Option B is worthwhile.
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