Reference no: EM132959461

Peter Piper is the manager of the Cypress Division (CD) of Howe Sound Manufacturing (HSM). The division produces a product, the A-100, used by manufacturers in all industries.

HSM is a national company with several divisions, including the CD. Divisional managers are given full autonomy over investment decisions. The divisions can apply to the corporate head office for funding to finance any acquisition as long as the project can be shown to have a positive net present value at a rate of return of 10%.

The production manager for the CD has been working on a proposal that would require an investment of $14,000,000 in new equipment. The equipment would replace the aging equipment that the division currently uses to produce the A-100. From the production manager's perspective, the equipment will have three advantages. First of all, it will reduce operating costs in the production of the A-100. The production manager believes machine time and direct labour time will be reduced by 20% and 30%, respectively. Secondly, it will allow for increased production of the A-100, allowing it to potentially capture more of the market. The marketing manager estimates that an extra 22,000 units could be sold if the company had the production capacity. The third advantage is that any excess capacity can be used to produce a second product the B-200. The division has not competed in this market for the last few years as the cost of manufacturing was prohibitive.

If the proposal is turned down, the production manager believes the current equipment can be used for another five years, at which time it will be worthless. If the new equipment is purchased, the current equipment would be scrapped for no value.

Peter knows that such a large investment would significantly change the division's business model. However, he is interested in long-term stability and sees this investment as an opportunity to achieve that objective.

Exhibit one provides information about the A-100. Exhibit two provides information about the B-200. Production of the B-200 is only possible if the new equipment is purchased. Exhibit three provides information relating to the equipment purchase.

Peter Piper has asked you to evaluate the proposed purchase of the new equipment. He advises you that the selling price for the A-100 has declined slightly due in 2020 to increased competition. He expects the unit selling price to remain at that level for the next five years. For purposes of your analysis, assume that all input costs will remain at 2020 levels, except as noted in the exhibits.

Required: Evaluate the proposal using discounted cash flows and net present value. Your response should include a supported recommendation for the proposed equipment acquisition, as well as any relevant qualitative issues.

Exhibit One - A-100 Operating Income and Other Product Information
Howe Sound Manufacturing
Cypress Division
Years Ended 2020
2020
Revenue $24,600,000
Variable costs:
Direct materials 6,225,000
Direct labour 7,425,000
Overhea 1 3,750,000
Selling & administration 1,230,000
Total variable costs 18,630,000
Contribution 5,970,000
Fixed costs:
Manufacturing 2 3,150,000
Selling & administration 2,250,000
Total fixed costs 5,400,000
Operating income $570,000
Assets employed:
Current 1,500,000
Property, plant & equipment 2,500,000
Sales volume 150,000

Note 1: Variable overhead costs are allocated based on machine hour capacity. The overhead rate is $31.25 per machine hour.
Note 2: Fixed manufacturing overhead includes $250,000 of depreciation expense. Depreciation expense is the only non-cash expense.
Exhibit Two - Product Information for B-200
Howe Sound Manufacturing
Cypress Division
Unit selling price $200.00
Variable costs:
Direct materials $55.00
Direct labor $25.00
Overhead ?
Selling & administration $10.00
Increase in fixed manufacturing costs (per year, excluding depreciation) $1,850,000 Machine time per unit 0.20 hrs.
Anticipated sales volume 100,000 units

Exhibit Three - Information on New Equipment Proposal
Howe Sound Manufacturing
Cypress Division
Cost of Equipment $14,000,000
Required rate of return 10%
Tax rate 30% CCA rate 20%
Residual value $500,000
Increase in fixed manufacturing costs (per year, excluding depreciation) $5,000,000 Increase in selling and administration fixed costs (per year) $700,000
Capacity in machine hours 125,000
Useful life of the equipment 5 years