This is a problem in managerial accounting. Can you give me some direction?
Office King Corp. makes three different models of paper shredders including the waste container that serves as the base. While the shredder heads are different for three models, the waste container is the same. The number of waste containers that Office King will need during the next five years is estimated as follows:
The equipment used to manufacture the waste container must be replaced because it is broken and cannot be repaired. Management is considering the purchase of robotic equipment to replace the old machinery. The new equipment would have a purchase price of $945,000. There will be a 2% discount if payment is made within 10 days. Company policy is to take all purchase discounts. The freight on the equipment would be $11,000, and installation costs would total $22,900. Freight and installation costs will be included in the equipment's cost basis for MACRS depreciation purposes. The equipment would be purchased in December of the current year and placed into service January 1, 20x1. It would have a 5-year useful life but would be treated as a 3-year property under MACRS because of the nature of the equipment. This equipment is expected to have a salvage value of $12,000 at the end of its useful life in 20x5. The new equipment will result in a 25% reduction in both direct labor and variable overhead. There will be an additional one-time permanent decrease in working capital requirements of $2,500, resulting from a reduction in direct-material inventories. This working capital reduction would be recognized in the analysis at the time of equipment acquisition. The old equipment is fully depreciated, and it can be sold for a salvage amount of $1,500.
Rather than replace the equipment, one of the production managers has suggested that the waste containers be purchased. Office King has no alternative use for the manufacturing space at this time, so if the waste containers are purchased, the old equipment would be left in place. One supplier has quoted a price of $27 per container. This price is $8 less than Office King's current manufacturing costs, which is as follows:
Direct material $8.00
Direct Labor 10.00
Variable overhead 6.00
General 4.00 11.00
Total manufacturing price per unit $35.00
Office King employs a plant wide fixed overhead rate in operations. If the waste containers are purchased outside, the salary and benefits of one supervisor, included in the overhead budget at $45,000, would be eliminated. There would be no other changes in the other cash and noncash items included in fixed overhead, except depreciation on new equipment. Office King is subject to a 40% income tax rate. Management assumes that all annual cash flows and tax payments occur at the end of the year and uses a 12% after tax discount rate.
1. Office King must decide whether to purchase the waste containers from an outside supplier or purchase the equipment to manufacture the waste containers. Calculate the net present value of the estimated after-tax cash flows and determine which of these two options to pursue.
2. Explain why some companies calculate the payback period of an investment in addition to determining the net present value.
3. Between what two consecutive whole number amounts is the payback period for the new equipment?