The Pittsburgh division of Vermont Machinery, Inc., manufactures drill bits.One of the production processes for a drill bit requires tipping, whereby carbide tips are inserted into the bit to make it stronger and more durable. This tipping process usually requires four or five operators, depending on the weekly workload. The same operators are also assigned to the stamping operation, where the size of the drill bit and the company's logo is imprinted on the bit. Vermont is considering acquiring three automatic tipping machines to replace the manual tipping and stamping operations. If the tipping process is automated, the division's engineers will have to redesign the shapes of the carbide tips to be used in the machine. The new design requires less carbide, resulting in savings on materials. The following financial data have been compiled: Project life: six years. Expected annual savings: reduced labor, $56,000; reduced material, $75,000; other benefits (reduced carpal tunnel syndrome and related problems), $28,000; reduced overhead, $15,000. Expected annual O&M costs: $22,000. Tipping machines and site preparation: equipment costs (for three machines), including delivery, $180,000; site preparation, $20,000. Salvage value: $30,000 (total for the three machines) at the end of six years. Depreciation method: seven-year MACRS. Investment in working capital: $25,000 at the beginning of the project year, which will be fully recovered at the end of the project year. Other accounting data: marginal tax rate of 39%; MARR of 18%.To raise $200,000, Vermont is considering the following financing options:Option 1: Finance the tipping machines by using retained earnings.Option 2: Secure a 12% term loan over six years (with six equal annual installments).Option 3: Lease the tipping machines. Vermont can obtain a six-year financial lease on the equipment (maintenance costs are taken care of by the lessor) for payments of $55,000 at the beginning of each year.(a) Determine the net after-tax cash flows for each financing option.(b) What is Vermont's PW cost of owning the equipment by borrowing? (c) What is Vermont's PW cost of leasing the equipment? (d) Recommend the best course of action for Vermont.
The Pittsburgh division of Vermont Machinery, Inc., manufactures drill bits.
One of the production processes for a drill bit requires tipping, whereby carbide tips are inserted into the bit to make it stronger and more durable. This tipping process usually requires four or five operators, depending on the weekly workload. The same operators are also assigned to the stamping operation, where the size of the drill bit and the company's logo is imprinted on the bit. Vermont is considering acquiring three automatic tipping machines to replace the manual tipping and stamping operations. If the tipping process is automated, the division's engineers will have to redesign the shapes of the carbide tips to be used in the machine. The new design requires less carbide, resulting in savings on materials. The following financial data have been compiled:
- Project life: six years.
- Expected annual savings: reduced labor, $56,000; reduced material, $75,000; other benefits (reduced carpal tunnel syndrome and related problems), $28,000; reduced
overhead , $15,000. - Expected annual O&M costs: $22,000.
- Tipping machines and site preparation: equipment costs (for three machines), including delivery, $180,000; site preparation, $20,000.
- Salvage value: $30,000 (total for the three machines) at the end of six years.
Depreciation method: seven-year MACRS.- Investment in
working capital : $25,000 at the beginning of the project year, which will be fully recovered at the end of the project year. - Other accounting data: marginal tax rate of 39%; MARR of 18%.
To raise $200,000, Vermont is considering the following financing options:
Option 1: Finance the tipping machines by usingretained earnings .
Option 2: Secure a 12% term loan over six years (with six equal annual installments).
Option 3: Lease the tipping machines. Vermont can obtain a six-year financial lease on the equipment (maintenance costs are taken care of by the lessor) for payments of $55,000 at the beginning of each year.
(a) Determine the net after-taxcash flows for each financing option.
(b) What is Vermont's PW cost of owning the equipment by borrowing? - (c) What is Vermont's PW cost of leasing the equipment?
(d) Recommend the best course of action for Vermont.
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