Replacement Decision. Wisconsin Products Company manufactures several different products. One of the firm’s principal products sells for $20 per unit. The sales manager of Wisconsin Products has stated repeatedly that he could sell more units of this product if they were available. In an attempt to substantiate his claim the sales manager conducted a market research study last year at a cost of $44,000 to determine potential demand for this product. The study indicated that Wisconsin Products could sell 18,000 units of this product annually for the next 5 years.
The equipment currently in use has the capacity to produce 11,000 units annually. The variable production costs are $9 per unit. The equipment has a book value of $60,000 and a remaining useful life of 5 years. The salvage value of the equipment is negligible now and will be zero in 5 years.
A maximum of 20,000 units could be produced annually on new machinery. The new equipment costs $300,000 and has an estimated useful life of 5 years, with no salvage value at the end of 5 years. Wisconsin Products’ production manager has estimated that the new equipment, if purchased, would provide increased production efficiencies that would reduce the variable production costs to $7 per unit.
Wisconsin Products Company uses straight-line depreciation on all its equipment for tax purposes
The sales manager felt so strongly about the need for additional capacity that he attempted to prepare an economic justification for the equipment although this was not one of his responsibilities. His analysis, presented below and on the next page, disappointed him because it did not justify acquisition of the equipment.
He computed the required investment as follows:
Purchase price of new equipment $300,000
Disposal of existing equipment
Loss on disposal $60,000
Less tax benefit (40%) 24,000 36,000
Cost of market research study 44,000
Total investment $380,000
He computed the annual returns as follows:
Contribution margin from product
Using the new equipment
[18,000 ´ ($20 $7)] $234,000
Using the existing equipment
[11,000 ´ ($20 $9)] 121,000
Increase in contribution margin $113,000
Less depreciation 60,000
Increase in before-tax income $53,000
Income tax (40%) 21,200
Increase in income $31,800
Less 15% cost of capital on the
additional investment required
(0.15 $380,000) 57,000
Net annual return on proposed
investment in new equipment $(25,200)
The controller of Wisconsin Products Company plans to prepare a discounted cash flow analysis for this investment proposal. The controller has asked you to prepare corrected calculations of (a) the required investment in the new equipment and (b) the recurring annual cash flows. Explain why your corrected calculations differ from the original analysis prepared by the sales manager. (c) Calculate the net present value of the proposed investment in the new equipment.