NPV, Relevant costs, Income taxes Phish Corporation is the largest manufacturer and distributor of novelty ice creams across the East Coast. The company’s products, because of their perishable nature, require careful packaging and transportation. Phish uses a special material called ICI that insulates the core of its boxes, thereby preserving the quality and freshness of the ice creams. Patrick Scott, the newly appointed COO, believed that the company could save money by closing the internal Packaging department and outsourcing the manufacture of boxes to an outside vendor. He requested a report outlining Phish Corporation’s current costs of manufacturing boxes from the company’s controller, Reesa Morris. After conducting some of his own research, he approached a firm that specialized in packaging, Containers Inc., and obtained a quote for the insulated boxes. Containers Inc. quoted a rate of $700,000 for 7,000 boxes annually. The contract would run for five years and if there was a greater demand for boxes the cost would increase proportionately. Patrick compared these numbers to those on the cost report prepared by Reesa. Her analysis of the packaging department’s annual costs is as follows:

Direct material (ICI) $ 80,000

Other direct material 120,000

Direct labor 220,000

Department manager’s salary 85,000

Depreciation of machinery 60,000

Department overhead 65,000

Rent 15,000

Allocation of general administrative overhead 70,000

After consulting with Reesa, Patrick gathers the following additional information:

i. The machinery used for production was purchased two years ago for $430,000 and was expected to last for seven years, with a terminal disposal value of $10,000. Its current salvage value is $280,000.

ii. Phish uses 20 tons of ICI each year. Three years ago, Phish purchased 100 tons of ICI for $400,000. ICI has since gone up in value and new purchases would cost $4,500 a ton. If Phish were to discontinue manufacture of boxes, it could dispose of its stock of ICI for a net amount of $3,800 per ton, after handling and transportation expenses.

iii. Phish has no inventory of other direct materials; it purchases them on an as-needed basis.

iv. The rent charge represents an allocation based on the packaging department’s share of the building’s floor space. Phish is currently renting a secondary warehouse for $27,000; this space would no longer be needed if the contract is signed with Containers Inc.

v. If the manufacture of boxes is outsourced, the packaging department’s overhead costs would be avoided. The department manager would be moved to a similar position in another group that the company has been looking to fill with an external hire.

vi. Phish has a marginal tax rate of 40% and an after-tax required rate of return of 10%.

Required

1. Sketch the cash inflows and outflows of the two alternatives over a five-year time period.

2. Using the NPV criterion, which option should Phish Corporation select?

3. What other factors should Phish Corporation consider in choosing between the alternatives?