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PV of cash flows

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RAP Manufacturing, Inc. produces microwave ovens, electric ranges, and freezers. Due to increasing competition, President Bob Pearson is considering investing in a computer-aided manufacturing (CAM) system. The company's microwave plant has been selected for initial evaluation. The CAM system for the microwave line would replace an existing system that was purchased one year ago for $6 million. Although the existing system will be fully depreciated nine years from now, it is expected to last another 10 years. The CAM system would have a useful life of 10 years.

Both the existing system and the CAM system are capable of producing 100,000 microwave units per year. Sales and production data relating to the existing system are:

Sales per year (units) 100,000
Selling price $300
Costs per unit:
Direct materials 80
Direct labor 90
Volume-related overhead 20
Direct fixed overhead 40*

*These are cash expenses with the exception of depreciation, which is $6 per unit. The existing equipment is being depreciated using the straight-line method with no salvage value considered.

The CAM system would cost $54 million to purchase and implement. It would be depreciated on a straight-line basis for tax purposes with no salvage value considered. Pearson's industrial engineers predict that the system could be sold for $4 million at the end of year 10. The CAM system would require fewer parts for production and would produce with less waste. As a result, direct materials cost per unit would be reduced by 25 percent. Direct labor would be reduced by two-thirds. Automation also would require fewer support activities, and as a consequence, volume-related overhead would be reduced by $5 per unit and cash fixed overhead (other than depreciation) would be reduced by $18 per unit.

If the CAM system were purchased, the existing system could be sold now for $3 million. The existing system would have no salvage value after another 10 years of use.

Pearson's cost of capital is 12%. Its tax rate is 40%.

Required:

Compute the present value of the cash flows for (1) the existing system and for (2) the CAM system. Use the table on the next page for the existing system and the table on the following page for the CAM system. For each system, enter the after-tax cash flows that take place at the beginning of year 1, if any, in the "0" column. Enter the after-tax cash flows that take place at the end of year 10, if any, in the "10" column. Enter the annual after-tax amount of any annuity in the "Annuity" column. Enter the appropriate present-value (discount) factor for each one-time cash flow or annuity in the "Present Value Factor" column. Add the amounts in the "Present Value" column to compute the present value of the system's cash flows.

For the annuities associated with each system, you may combine the cash revenues and cash expenses as appropriate. For example, it is not necessary to compute the present value of after-tax direct materials cost, the present value of after-tax direct labor cost, and so on. However, show the after-tax cash flow associated with cash revenues and expenses separately from the after-tax cash flow associated with any noncash expense.

In the "Item" column of each table, enter a brief description of the cash flows on each row. Examples include Purchase of CAM System, Sale of Existing System, and Depreciation Tax Savings.

Based on your analysis, what should RAP do? Briefly, why?

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Solution Summary

The solution explains now to calculate the PV of cash flows of the existing system and a new system

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