Reference no: EM132166007

Mini case - Victoria's Equipment Manufacturing Ltd

Victoria's Equipment Manufacturing Ltd (VEM) fabricates a specialized drilling machine (the CF128) for the resource industries. They work with large consulting firms and the resource companies around the world and are running their manufacturing shop at full capacity. Although they keep up with current demand for the drilling machine they sell, the CF128, VEM has an opportunity to purchase a new manufacturing system. It is called the Integrated Drilling Machine System (or IDMS for short) that would allow them to produce many different types of drilling machines, not just the CF128. The IDMS has an increased production capacity of 120% over the current shop machinery. In order to purchase the IDMS they would have to stop work on their current jobs to dismantle and clear out their current shop machines and then install the new IDMS. They expect the down time to last 4 weeks and to cost VEM $50,000 per week in lost profits and costs. In addition, VEM will have to lay off three current operators at $20,000 each. There is also a significant training cost to learning how to properly run the 3D printer, which has been determined to be $75,000. The upside is reduced wage costs (estimated at $60,000 per person per year) as the number of people involved in manufacturing would drop from 9 to 6. Maintenance costs on the IDMS increase over time; the first year is expected to be zero; year's 2 to 4 are forecasted at $15,000 per year, and year's 5 to 8 are budgeted at $25,000 per year. Maintenance costs on the current machinery average $30,000 per year. Utility costs are expected to decrease by $850 per month.

Victoria has talked to her bank, which will loan her S500.000 at an 8% rate to assist with the purchase of the IDMS; the loan requires an annual interest payment and a lump sum payment of the $500,000 at the end of five years. She believes she could sell the machinery in her current shop for $150,000, which would give her enough cash, along with her current cash in the bank, to purchase the IDMS at a cost of $1,200,000. There is an upfront payment of $900,000 ($500,000 from the bank and $400,000 from cash) and a second payment of $300,000 at the end of year 1.

The estimated life on the IDMS is 8 years with an estimated residual value of $150,000. Her current machinery would also last 8 years but would have no residual value and would require repairs in year 1 ($24,000), year 3 ($28,000), year 5 ($32,000) and year 7 ($36,000), Victoria requires an 11% rate of return on all investments.

Required - You are to prepare a report to Victoria Lao, President of VEM, covering the following two scenarios:

A) Assuming no increase in sales should Victoria Manufacturing purchase the IDMS and replace their current machinery? Explain why or why not.

B) What increase in annual sales would make the NPV of the IDMS purchase acceptable?

C) After calculating the answer to B would you amend your answer to A?