Rob Thorton is a member of the planning and analysis staff for Thurston, Inc., an established manufacturer of frozen foods. Rick Ungerman, chief financial officer of Thurston, Inc., has asked Thorton to prepare an analysis of net present value for a proposed capital equipment expenditure that should improve the profitability of the southwestern plant. This analysis will be given to the board of directors for expenditure approval. Several years ago, as director of planning and analysis, Ungerman was instrumental in convincing the board to open the southwestern plant. However, recent competitive pressures have forced each of Thurston’s manufacturing divisions to consider alternatives to improve their market position. To Ungerman’s dismay, the southwestern plant may be sold in the near future unless significant improvements in cost control and production efficiency are achieved.
The southwestern plant’s production manager, an old friend of Ungerman’s, has submitted a proposal for the acquisition of an automated materials-movement system. Ungerman is eager to have this proposal approved, as it will ensure the continuance of the southwestern plant and preserve his friend’s position. The plan calls for the replacement of a number of forklift trucks and operators with a computer-controlled conveyor belt system that feeds directly into the refrigeration units. This automation would eliminate the need for a number of materials handlers and increase the output capacity of the plant.
Ungerman has given this proposal to Thorton and instructed him to use the information in the subsequent table to prepare his analysis.
The forklift trucks have been fully depreciated and have a zero net book value. If the conveyor belt system is purchased now, these trucks will be sold for $100,000. Thurston has a 40 percent effective tax rate, has chosen the straight-line depreciation method, and uses a 12 percent after-tax discount rate. For the purpose of analysis, all tax effects and cash flows from the equipment acquisition and disposal are considered to occur at the time of the transactions, whereas those from operations are considered to occur at the end of each year.
When Thorton completed his initial analysis, the proposed project appeared quite healthy.
Projected useful life ....................10 years
Purchase/installation of equipment .............$4,500,000
Increased working capital needed* ..............1,000,000
Increased annual operating costs (exclusive of depreciation).....200,000
Equipment repairs to maintain production efficiency (end of year 5)..800,000
Increase in annual sales revenue.................700,000
Reduction in annual manufacturing costs............500,000
Reduction in annual maintenance costs...............300,000
Estimated salvage value of conveyor belt system...........850,000
*The working capital will be released at the end of the 10-year useful life of the conveyor belt system.
However, after investigating equipment similar to that proposed, he discovered that the estimated residual value of $850,000 was very optimistic; information several vendors had previously provided estimates this value to be $100,000. He also discovered that industry trade publications considered eight years to be the maximum life of similar conveyor belt systems. As a result, he prepared a second analysis, based on this new information. When Ungerman saw the second analysis, he told Thorton to discard this revised material, warned him not to discuss the new estimates with anyone, and ordered him not to present any of this information to the board of directors.
A. Prepare an analysis of the net present value of the purchase and installation of the materials movement system, using the revised estimates obtained by Thorton. Be sure to present supporting calculations.
B. Accurately describe the decision problem facing Thorton.
C. What alternatives does he have?
D. What is the best alternative from a quantitative analysis?
E. What other qualitative factors should be considered and why?