Porter & Alexander Auto Corporation Ms. Kathy Mc Kita, the chief budgeting analyst at Porter & Alexander Auto Corporation (PAAC) is preparing the firm’s capital budget for 2018. PAAC has two divisions. One builds cars (the Automotive Division). The other reduces old cars to reusable scrap (the Scrap Division). Most of the analysis for 2018 projects has been completed. Ms. McKita is refining the analysis of one more project.
This project is one that is expected to have no impact on sales revenue but is expected to reduce manufacturing costs in the Automotive Division. The capital investment for the equipment required for the project in question is $200,000. Setup costs associated with the new equipment are expected to add another 15 percent to the initial investment amount. Ms. McKita believes that the investment and set-up costs associated with buying and setting up the equipment will be written off to zero using the 3-year Recovery Period Class (See MACRS schedule in the case packet).
The equipment is expected to have a five-year operating life. At the end of that period, the machinery is expected to be sold to the Scrap Division for $15,000. It is expected that the Scrap Division will process the machine for scrap at an incremental cost of $10,000 and sell the scrap for $30,000 at that time. Ms. McKita expects that total projected sales revenue in the automotive division in 2018 will be $1,000,000 and expects revenues to grow by 5 percent per year for the next four years due to inflation (i.e., the number of units sold per year is expected to be unchanged).
The expected benefits of the new equipment are twofold. First, Ms. McKita expects to reduce direct labor costs by 8% of total sales revenue each year for five years. Second, Ms. McKita expects that the new machine will reduce scrap created in the manufacturing process by 2000 pounds per year. Each pound of scrap reduction results in a net savings of $5 per pound.
The nominal price per pound is not expected to change. The new machinery is very sensitive to the intensity with which it will be used and might require extensive annual maintenance. Ms. McKita expects maintenance costs to be $28,000 per year, is not exactly sure how to estimate the maintenance cost, but is sure that whatever they are, they will be a tax-deductible expense in the period in which they are incurred.
The nominal cost of maintenance is not expected to change. The Chief Financial Officer (CFO), Mr. Thomas Tedrow, has indicated that regardless of the source of financing used, the nominal after-tax cost of capital for all projects considered by the automotive division is 15% for the foreseeable future. He has also indicated that a tax rate of 40 percent should be used in all analyses. Mr. Tedrow recognizes that the objective of capital expenditures is to maximize the value of PAAC’s common stock. The questions confronting Ms. McKita are:
1. Should the Automotive Division invest in labor-saving equipment?
2. Suppose Ms. McKita decides to use straight-line depreciation over 3 years. What would happen to the project’s NPV?
3. Suppose now that in addition to labor savings and quality improvements, the new equipment is expected to enhance working capital productivity. Specifically, suppose that the firm’s expected required investment in work-in-progress inventory will decline from 20 percent of sales to 15 percent of sales.
How, if at all, would this change Ms. McKita’s analysis and conclusions? (Use 3-year MACRS Depreciation Schedule as before.) Note: remember, this project lasts for 5 years. At the end of that period, operations return to “normal.”
4. Suppose that the project is financed 50% with debt and 50% equity. Where do the interest costs show up in the analysis?
5. With the data that she has, could Ms. McKita calculate the payback period? Could she calculate the IRR?