POW 11-Tabitha's Toys-F2023 (1)
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School
Brigham Young University *
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201
Subject
Industrial Engineering
Date
Jan 9, 2024
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docx
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Uploaded by CountStrawRaven30
TABITHA’S TOYS
Capital Budgeting Case with Risk & Return Component
Tabitha’s Toys specializes in the manufacture of toys for children of all ages. In the Tabitha plant, parts
for Tabitha’s smaller toys are machined on two converted metal lathes. These lathes were purchased in
used condition six years previously, and the remaining net book value of each is $5,000
(35% of the initial
cost). The lathes are being depreciated on the straight-line method to a $0 salvage value. Larger toys
have been made using a small boring mill, which is fully depreciated to a $0 salvage value. All three
pieces of equipment (the two converted lathes and the boring mill) are badly worn, and considerable
difficulty had been encountered in making toys to meet production specifications. In the opinion of the
industrial engineering supervisor, it is necessary either to overhaul or replace the machines (continued
operation without an overhaul or replacement is
not
an option).
Option #1: Replacement
One option is to replace the present lathes and
boring mill with two
new automatic lathes. These two new
lathes have precision programming that enable the manufacture of both large and small toys, eliminating
the need for a boring mill. The estimated cost of these lathes is $22,000 each. There will also be a charge
of $1,075 per lathe for installation and delivery costs. Tabitha will pay a 6.5% sales tax on the purchase of
the lathes and $500 per lathe in maintenance set-up fees to properly calibrate the lathes to Tabitha’s
unique product specifications before production can begin.
Brielle Baumgartner, the engineering supervisor, estimates that each of the new lathes will have a
physical life of 10 years. Ms. Baumgartner also believes they will have a 20% greater capacity than the
old machines (i.e., they will permit a 20% increase in physical output with the same labor hours). Each of
the new lathes will be depreciated on a straight-line basis over 10 years to a $1,100 salvage value. Ms.
Baumgartner estimates that installing the two new lathes in place of the old machines will free
approximately 250 square feet of floor space within the main production facility. Although Tabitha Toys
has no immediate alternative use for the space, rent, heat, and light are allocated on a space basis and
charged at an annual rate of $3 per square foot.
Because of the speed of the new lathes, additional raw materials inventory must be maintained. With the
new lathes, it is estimated that investment in this inventory (also known as net working capital) will be
$1,650, and that this investment will be fully recovered at the end of the 10
th
year.
Direct labor costs with the present lathes and boring mill are approximately $20,000 per year. However,
with the two new lathes it is estimated that even with the same volume of production, these costs will be
cut to about $14,100 per year. There will also be a reduction in the allocation of general overhead costs
*
to this department.
Such costs are currently allocated on the basis of 15% of direct labor.
Option #2: Overhaul
The second option to overhaul the two old lathes involves the installation of new bedways, headstocks,
carriages, and tool feeds at an estimated cost of $6,700 in direct labor and parts for each lathe.
Additional repairs required to put the boring mill in satisfactory condition are estimated to be $540 in
direct labor and parts. Ms. Baumgartner believes these repairs will prolong the life of the lathes and
boring mill approximately 10 years, although for income tax purposes the “cost” of the rebuilt machines
(present book value plus the cost of overhaul) will be amortized on a straight-line basis to a $0 salvage
value over seven years.
The “normal” annual maintenance costs for the two present lathes are approximately $1,400 higher than
estimated annual maintenance costs for the two new lathes.
Ms. Baumgartner believes that “normal”
maintenance costs will remain roughly unchanged if the present lathes are repaired. Current
maintenance for the boring mill is $500 annually and will remain the same after the overhaul.
Looking ahead, company officials are confident that sales will equal, if not exceed, their current volume
for the foreseeable future. Sufficient funds are available to either 1) purchase the new equipment or 2)
make the repairs; whichever option is better for Tabitha’s Toys. The company’s corporate income tax rate
*
*
Accounting, general maintenance, and mail room.
is 35%, and it estimates its after-tax cost of capital at 12.0%. Using your knowledge of capital budgeting
analysis, which of these two options should be selected by Tabitha’s Toys? Why?
Exhibit 1: Lathe
Exhibit 2: Boring Mill
Industry Analysis
After you have completed your capital budgeting analysis, you decide to analyze the risk and return for
two other companies in the toy making industry to compare them with Tabitha’s Toys. You decide to look
at the risk and return of two of Tabitha’s Toys’ top competitors: Happy Children’s Toys, Inc. and Toy
Town, Inc. Below is a chart presenting information for the risk and return each company is expecting in
the future.
1) Calculate the expected return and standard deviation for Happy Children’s Toys and Toy Town. As an
investor, which of these two companies would you want to invest in? Why?
2) You know that Tabitha’s Toys’ cost of capital (i.e., expected return) is 12.0%, with a corresponding
standard deviation of 4.5%. How does Tabitha’s Toys compare to their two top competitors?
Chart 1: Expected Rates of Return for Happy Children’s Toys
State of Economy
Probability of State of
Economy Occurring
Expected Return
Recession
0.20
-0.01
Normal
0.55
0.10
Boom
0.25
0.15
Chart 2: Expected Rates of Return for Toy Town
State of Economy
Probability of State of
Economy Occurring
Expected Return
Recession
0.20
0.03
Normal
0.55
0.11
Boom
0.25
0.16
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