International Hoists is one of the largest producers of hoists of all types. An especially complex part of a particular auto hoist needs special tools that are not useful for other products. The company purchased these tools on July 1, 20X0, for $2,000,000.

It is now July 1, 20X4. The manager of the auto hoists division, David Lee, is contemplating three alternatives. First, he could continue to produce the ship using the current tools; they will last another 5 years, at which time they would have zero terminal value. Second, he could sell the tools for $400,000 and purchase the parts from an outside supplier for $110 each. Third, he could replace the tools with new, more efficient tools costing $1,800,000.

Lee expects to produce 8,000 units of this particular hoist each of the next 5 years. Manufacturing costs for the hoist have been as follows, and no change in costs is expected:

Direct materials ………. $ 38

Direct labor …………….. 37

Variable overhead ……… 17

Fixed overhead* ………. 45

Total unit cost ………. $137

The outside supplier offered the $110 price on a 5-year contract as a once-only offer. It is unlikely it would make such a low price available later. International Hoists would also have to guarantee to purchase at least 7,000 parts for each of the next 5 years.

The new tools that are available would last for 5 years with a disposal value of $500,000 at the end of 5 years. The old tools are a 5-year MACRS property, the new tools are a 3-year MACRS property, and both use the current MACRS schedules. International Hoists uses straight-line depreciation for book purposes and MACRS for tax purposes. The sales representative selling the new tools stated, “The new tools will allow direct labor and variable overhead to be reduced by $21 per unit.” Lee thinks this estimate is accurate. However, he also knows that a higher quality of materials would be necessary with the new tools. He predicts the following costs with the new tools:

Direct materials …………. $ 40

Direct labor ……………… 25

Variable overhead ………… 8

Fixed overhead ………… 60*

Total unit cost ………… $133

*The increase in fixed overhead is caused by depreciation on the new tools.

The company has a 40% marginal tax rate and requires a 12% after-tax rate of return.

1. Calculate the NPV of each of the three alternatives. Recognize the tax implications. Which alternative should Lee select?

2. What are some factors besides the NPV that should influence Lee’s selection?