Strategic Capital Investment Decisions
Smith Electronics manufactures portable CD players. Lillian Perez, the VP of operations at Smith Electronics, is considering a major capital investment decision. It would cost $2,500,000 to put new, highly automated machines in the factory. The equipment would last about 15 years and would have no salvage value at the end of that period. The equipment will replace 10 workers, saving Smith $300,000 per year in direct labor. Operation and maintenance costs on the machines are expected to cost $100,000 per year. The automated equipment is expected to improve quality. Smith's main competitors are installing similar equipment. If Smith installs the equipment, its revenues are expected to remain steady. If Smith chooses not to install new equipment, its contribution margins expected to fall by $200,000 per year as a result of lower quality compared to its competitors. Smith's discount rate is 10% and its tax rate is 30%.
A. How much is Smith expected to save each year if it installs the equipment (including tax effects)?
B. How much will Smith lose each year if it does not install the equipment (including tax effects)?
C. Explain how you would analyze this problem in order to determine if Smith should purchase the new machines.
D. Should Smith purchase the new machine?
E. Assume that programming and maintenance costs turn out to be much higher than Lillian's estimates. However, despite the fact that the automation equipment increased costs, Lillian still wants to continue with the project Explain why Lillian might not want to scrap the equipment.
This solution shows step-by-step calculations in an Excel file to determine the net savings in cash, net loss as well as an analysis on the purchasing of the equipment.