Chapter 17, Problem 69P

1.

To determine

Determine the total required initial cash outlay related with new manufacturing equipment.

Explanation of Solution

Determine the total required initial cash outlay related with new manufacturing equipment.

Particulars	Amount
Cost of new equipment and installation	$12,000,000
Training	$3,000,000
Total investment required	$15,000,000

Table (1)

2.

To determine

Compute total expected change in cost of quality over the next 3 years.

Explanation of Solution

Compute Estimated total annual cost of quality (COQ) if no change is made.

Particulars	Amount	Amount
Rework $\left[\left(3,000\text{ units}\times \text{40\%}\right)\times \$2,000\text{ per unit}\right]$		$2,400,000
Repair    $\left[\left(3,000\text{ units}\times \text{15\%}\right)\times \$2,500\text{ per unit}\right]$		$1,125,000
Appraisal:
Fixed	$600,000
Variable inspection $\left(3,000\text{ units}\times \text{\$50 per unit}\right)$	$150,000	$750,000
Foregone contribution from lost sales:
Contribution margin per unit $\left(\$12,000-\$2,500-\left[\$12,000\times 15\%\right]\right)$	$7,700
Multiply: Lost sales (units) $\left(\left(\frac{3,000}{80\%}\right)\text{ units}-3,000\right)$	750	$5,775,000
Total current cost of quality (COQ) per year		$10,050,000

Table (2)

Determine the expected three-year increase or decrease in total COQ:

Particulars	Amount
Current COQ	$10,050,000
Less: Warranty repair costs (1)	($187,500)
Pre-tax savings in COQ	$9,862,500
Multiply: Life of the project	3 years
Gross savings over three-year period	$29,587,500
Less:  Appraisal and inspection cost incurred, Year 1 $\left(\$600,000+\left[\$50\text{ per unit}\times 3,000\text{units}\right]\right)$	($750,000)
Net decrease(increase) in quality costs over 3- year period.	$28,837,500

Table (3)

Working note 1:  Calculate the warranty repair costs:

$\begin{array}{c}\begin{array}{l}\text{Warranty repair costs}\\ \text{ associated with revised units }\\ \text{sold }\left(\text{under the new process}\right)\end{array}\}=\left(\begin{array}{l}\text{Revised sales }\\ \text{volume}\end{array}\right)\times \left(\begin{array}{l}\text{Repair rate based}\\ \text{ on total unit sales}\end{array}\right)\times \left(\begin{array}{l}\text{Warranty repair}\\ \text{ cost per unit}\end{array}\right)\\ =\left[\left(\frac{3,000\text{ units}}{0.8}\right)\times 5\%\right]\times \$1,000\text{ per unit}\\ \text{=}\left[3,750\text{ units}\times \text{5}\%\right]\times \$1,000\\ =\$187,500\end{array}$

3. a

To determine

Explain whether Corporation W should invest in new process and compute the cumulative change in pretax cash flow assuming the implementation of new system.

Explanation of Solution

Explain whether Corporation W should invest in new process and compute the cumulative change in pretax cash flow assuming the implementation of new system.

The cost of the new process is $15,000,000 and the expected three-year savings amount to $28,837,500. This amounts to a net pre-tax cash flow increase of $13,837,500 over the three-year period.

3. b

To determine

Determine the payback period for the proposed investment.

Explanation of Solution

As shown below, the payback period for this proposed investment is between 1 and 2 years (assuming that the pre-tax cash flows occur evenly throughout the year).

Year	Amount	Cumulative net cash flow (Pre-tax)
0	($ 15,000,000.00)	($ 15,000,000.00)
1	$ 9,112,500.00 (2)	($ 5,887,500.00)
2	$ 9,862,500.00	$ 3,975,000.00
3	$ 9,862,500.00	$ 13,837,500.00

Table (4)

Working note (2): Determine the amount for Year 1:

$\begin{array}{c}\text{Amount in Year 1}=\$9,862,500-\$750,000\\ =\$9,112,500\end{array}$

3. c

To determine

Compute the estimated pretax internal rate of return (IRR) for the proposed investment.

Explanation of Solution

The estimated pre-tax internal rate of return (IRR) for the proposed investment is calculated below:

Table (5)

Note: The IRR has been calculated by using the excel formula (=IRR (C10:C13,0.25)).

Thus, the estimated pretax internal rate of return (IRR) for the proposed investment is 40.7%

4.

To determine

Identify the additional factors that should be considered prior to the making of financial decision.

Explanation of Solution

The additional factors that should be considered before making the final decision are given below:

1. 1. Accuracy of cost estimates, including:
   • Contribution margin per unit
   • Cost of current repair and rework
   • Cost of repair with the new process
   • Cost of the new process
2. 2. Reliability of estimations of:
3. • Rate of rework and rate of repair.
4. • Lost sales.
5. • Amount of time before the current equipment becomes obsolete.
6. 3. Reaction of competitors and the Time value of money factor (discount rate) for capital budgeting decision making.

5.

To determine

Explain whether the statement made by member of the board of directors are agreeable or not.

Explanation of Solution

The member of the board might be right if the financial payoff of the new process is ignored and if the company is going to operate for only three years. The sale of high-end product having higher quality by the company is vital for a long-term success.

In more concrete financial terms, the company needs to consider the factors given below:

• Potential opportunity costs: The company has to decide the possibility of losing customers over time such that these customers may be completely unwilling to consider buying anything ever again from the company, even if it is a new model.
• Pricing: In the absence of investment, the company has to assess its ability for maintaining the price competition if the rivals of the company are incurring lower costs due to lower failures. The competitors might sell products at lower prices and gain market share if Corporation W doesn’t match (or beat) their pricing.

In short, Corporation W is producing a high-end product; it is competing based on differentiation, but it is not necessary that the company doesn’t have competitors also competing as differentiators.