Question

LifeLine Corporation manufactures fire extinguishers. One part used in all types of fire extinguishers is a unique pressure fitting that requires specialized machine tools that need to be replaced. LifeLine’s production manager has concluded that the only alternative to replacing these machine tools is to buy the pressure fitting from Milwaukee Pipe and Fitting Company. LifeLine could buy the fitting for $20 if a minimum order of 70,000 fittings is placed annually. LifeLine has used an average of 80,000 fittings over the past three years. The production manager believes this volume will remain constant for five more years.
Cost records indicate that unit manufacturing costs for the last several years have been as follows:
Direct material..................................................................... $ 4.10
Direct labor.......................................................................... 3.70
Variable overhead................................................................ 1.70
Fixed overhead*.................................................................. 4.50
Total unit cost..................................................................... $14.00
*Depreciation accounts for two-thirds of the fixed overhead. The balance is for other fixed-overhead costs of the factory that require cash expenditures.
If the specialized tools are purchased, they will cost $2,500,000 and will have a disposal value of $100,000 after their expected life of five years. Straight-line depreciation is used for book purposes, but MACRS is used for tax purposes. The specialized tools are considered 3-year property for MACRS purposes. The company has a 40 percent tax rate, and management requires a 12 percent after-tax return on investment.
The sales representative for the manufacturer of the new tools stated, “The new tools will allow direct labor and variable overhead to be reduced by $1.60 per unit.” Data from another manufacturer using identical tools and experiencing similar operating conditions, except that annual production generally averages 110,000 units, confirm the direct-labor and variable-overhead savings. However, the manufacturer indicated that it experienced an increase in direct-material cost to $4.50 per unit due to the higher quality of material that had to be used with the new tools.

Required:
1. Prepare a net-present-value analysis covering the life of the new specialized tools to determine whether management should replace the old tools or purchase the pressure fittings. Include all tax implications.
2. Identify any additional factors management should consider before a decision is made to replace the tools or purchase the pressure fittings.
(CMA, adapted)



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  • CreatedApril 22, 2014
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