Kennington Corporation is evaluating a capital expenditure proposal to acquire and install a computer integrated manufacturing system.

Question:

Kennington is evaluating a capital expenditure proposal to acquire and install a computer integrated manufacturing system. The proposed CIM system will have the same total productive capacity as the current manufacturing system. The computer equipment and machinery will require an initial cash investment of $1,000,000. The system has a projected life of 6 years; however, the equipment and machinery will qualify as 5-year property for income tax depreciation purposes. The income tax rate is 40%. In addition, installation and software development are expected to cost another $200,000 in the first year. Software costs are amortizable for tax purposes by the straight-line method over a 5-year period. Maintenance costs are expected to increase by $10,000 a year over the current system. The annual cash savings from the CIM system relative to the current manufacturing system (before any adjustment for inflation or income taxes) are expected to be as follows:

Kennington Corporation is evaluating a capital expenditure proposal to acquire

The salvage value expected at the end of the project is zero. An annual inflation rate of 6% is expected to affect all cash flows over the life of the project.
Required:
(1) Compute the inflation-adjusted after-tax cash inflow from savings for the CIM proposal for each year, and determine whether the total cash savings from the CIM system will exceed the system's cost. (Use the MACRS depreciation rates provided in Exhibit 22-4 for the equipment and machinery, and compute straight-line amortization for the software. Round the price-level index to three decimal places.)
(2) In addition to the facts already presented, assume management believes its principal competitor plans to acquire a CIM system. Unless the company acquires a CIM system, it will not able to compete effectively. Management estimates that without the CIM system, it will lose sales amounting to a loss in contribution margin of $200,000 each year (before the effects of inflation are considered). Based on this new information, recompute the after-tax cash inflow for each year, and determine whether the total cash savings from the CIM system will exceed the system's costs.

Contribution Margin
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