The Pittsburgh Division of Vermont Machinery Inc, manufactures drill bits. One of the production processes of a drill bit requires tipping, whereby de tips are inserted into the bit to make it stronger and more durable. The tipping process usually requires four or five operators, depending on the weekly workload. The same operators are assigned to the stamping operation, in which the size of the drill bit and the company's logo are imprinted into the bit. Vermont is considering acquiring three automatic tipping machines to replace the manual tipping and stamping operations. If the tipping process is automated, Vermont engineers will have to redesign the shapes of the carbide tips to be used in the machines. The new design requires less carbide, resulting in a savings of material. The following financial data have been compiled.
• Project life: Six years.
• Expected annual savings: Reduced labor, $56,000; reduced material, $75,000; other benefits (reduction in carpal tunnel syndrome and related problems), $28,000; and reduced overhead, $15,000.
• Expected annual O&M costs: $22,000.
• Tipping machines and site preparation: Equipment costs (three machines), including delivery, $180,000; site preparation, $20,000.
• Salvage value: $30,000 (three machines) at the end of six years.
• Depreciation method: Seven-year MACRS.
• Investment in working capital: $25,000 at the beginning of the project year. That same amount will be fully recovered at the end of the project year.
• Other accounting data: Marginal tax rate of 39% and MARR of 18%.
To raise $200,000, Vermont is considering the following financing options:
• Option 1: Use the retained earnings of the tipping machines to finance them.
• Option 2: Secure a 12% term loan over six years (to be paid off in six equal annual installments).
• Option 3: Lease the tipping machines. Vermont can obtain a six-year financial lease on the equipment (with, however, no maintenance service) for payments of $55,000 at the beginning of each year.
(a) Determine the net after-tax cash flows for each financing option.
(b) What is Vermont's present-value cost of owning the equipment by borrowing?
(c) What is Vermont's present-value cost of leasing the equipment?
(d) Recommend the best course of action for Vermont.