Chapter 19, Problem 31P

Jonfran Company manufactures three different models of paper shredders including the waste container, which serves as the base. While the shredder heads are different for all three models, the waste container is the same. The number of waste containers that Jonfran will need during the following years is estimated as follows:

The equipment used to manufacture the waste container must be replaced because it is broken and cannot be repaired. The new equipment would have a purchase price of $945,000 with terms of 2/10, n/30; the company’s policy is to take all purchase discounts. The freight on the equipment would be $11,000, and installation costs would total $22,900. The equipment would be purchased in December 20x4 and placed into service on January 1, 20x5. It would have a five-year economic life and would be treated as three-year property under MACRS. This equipment is expected to have a salvage value of $12,000 at the end of its economic life in 20x9. The new equipment would be more efficient than the old equipment, resulting in a 25 percent reduction in both direct materials and variable overhead. The savings in direct materials would result in an additional one-time decrease in working capital requirements of $2,500, resulting from a reduction in direct material inventories. This working capital reduction would be recognized at the time of equipment acquisition.

The old equipment is fully depreciated and is not included in the fixed overhead. The old equipment from the plant can be sold for a salvage amount of $1,500. Rather than replace the equipment, one of Jonfran’s production managers has suggested that the waste containers be purchased. One supplier has quoted a price of $27 per container. This price is $8 less than Jonfran’s current manufacturing cost, which is as follows:

Jonfran uses a plantwide fixed overhead rate in its operations. If the waste containers are purchased outside, the salary and benefits of one supervisor, included in fixed overhead 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 the new equipment.

Jonfran is subject to a 40 percent tax rate. Management assumes that all cash flows occur at the end of the year and uses a 12 percent after-tax discount rate.

Required:

1. 1. Prepare a schedule of cash flows for the make alternative. Calculate the NPV of the make alternative.
2. 2. Prepare a schedule of cash flows for the buy alternative. Calculate the NPV of the buy alternative.
3. 3. Which should Jonfran do—make or buy the containers? What qualitative factors should be considered? (CMA adapted)

To determine

Calculate the cash flow and net present value (NVP) for make alternative of Company J.

Explanation of Solution

Cash inflows: The amount of cash received by a company from the operating, investing, and financing activities of the business during a certain period is referred to as cash inflow.

Cash outflows: The amount of cash paid by a company for the operating, investing, and financing activities of the business during a certain period is referred to as cash outflow.

Net present value method (NVP): Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is desired by the business based on the net income from the investment, and it is also called as the discounted cash flow method.

Calculate the cash flow and net present value (NVP) for make alternative of Company J as follows:

Year	Cash inflow (9) (A)	Present value factor @12% (B)	Present value $\left(A\times B\right)$
2015	$ -499,013	0.893	-$ 445,619
2016	$ -456,312	0.797	-$ 363,681
2017	$ -594,130	0.712	-$ 423,021
2018	$ -658,546	0.636	-$ 418,835
2019	$ -679,800	0.567	-$ 385,447
Total present value			-$ 2,036,602
Less: Cash outflow for investment (7)			$ 956,600
Net present value			($ 2,993,202)

Table (1)

Working note (1):

Calculate the variable cost per unit.

$\begin{array}{c}\text{Variable cost per unit = Direct material cost per unit+Direct labor cost per unit+Variable overhead}\\ \text{=}\left(\text{\$10}\times \text{0}\text{.75}\right)+\left(\$8\times 1.00\right)+\left(\$6\times 0.75\right)\\ =\$7.50+\$8.00+\$4.50\\ =\$20\end{array}$

Working note (2):

Calculate the variable cost after tax for each year.

Year 2015:

$\begin{array}{c}\text{Variable cost = }\left(\begin{array}{l}\text{Number of wates continers}\times \\ \text{Variable cost per continer (1)}\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\left(50,000\times \$20\right)\times \left(1-40\%\right)\\ =\$600,000\end{array}$

Year 2016:

$\begin{array}{c}\text{Variable cost = }\left(\begin{array}{l}\text{Number of wates continers}\times \\ \text{Variable cost per continer (1)}\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\left(50,000\times \$20\right)\times \left(1-40\%\right)\\ =\$600,000\end{array}$

Year 2017:

$\begin{array}{c}\text{Variable cost = }\left(\begin{array}{l}\text{Number of wates continers}\times \\ \text{Variable cost per continer (1)}\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\left(52,000\times \$20\right)\times \left(1-40\%\right)\\ =\$624,000\end{array}$

Year 2018:

$\begin{array}{c}\text{Variable cost = }\left(\begin{array}{l}\text{Number of wates continers}\times \\ \text{Variable cost per continer (1)}\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\left(55,000\times \$20\right)\times \left(1-40\%\right)\\ =\$660,000\end{array}$

Year 2019:

$\begin{array}{c}\text{Variable cost = }\left(\begin{array}{l}\text{Number of wates continers}\times \\ \text{Variable cost per continer (1)}\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\left(55,000\times \$20\right)\times \left(1-40\%\right)\\ =\$660,000\end{array}$

Working note (3):

Calculate the fixed cost after tax for each year.

$\begin{array}{c}\text{Fixed cost after tax = Fixed cost }\times \left(1-\text{Tax rate}\right)\\ =\$45,000\times \left(1-40\%\right)\\ =\$27,000\end{array}$

Working note (4):

Calculate the operating expense for each year.

Year	Variable cost (2) (E)	Fixed cost (3) (F)	Total operating expense $\left(E+F\right)$
2015	$600,000	$27,000	$627,000
2016	$600,000	$27,000	$627,000
2017	$624,000	$27,000	$651,000
2018	$660,000	$27,000	$687,000
2019	$660,000	$27,000	$687,000

Table (2)

Working note (5):

Calculate the initial investment.

$\begin{array}{c}\text{Initial investment = }\left[\begin{array}{l}\left(\text{Purchase price }-\text{Discount}\right)+\\ \text{Frieght expense+Installation cost}\end{array}\right]\\ =\left[\left(\$945,000-\left(\$945,000\times \frac{2}{100}\right)\right)+\$11,000+\$22,900\right]\\ =\$945,0000-\$18,900+\$11,000+\$22,900\\ =\$960,000\end{array}$

Working note (6):

Calculate the depreciation expense after tax for each year.

Depreciation Schedule
Year	MACRS Percentage (W)	Depreciation $X=\left(W\times \$960,000(5)\right)$	Tax Rate (Y)	Depreciation Tax Shield $\left(X\times Y\right)$
2015	33.33%	$319,968	40%	$127,987
2016	44.45%	$426,720	40%	$170,688
2017	14.81%	$142,176	40%	$56,870
2018	7.41%	$71,136	40%	$28,454
Total		$960,000

Table (3)

Working note (7):

Calculate the cash outflow for new equipment.

$\begin{array}{c}\text{Cash outflow = }\left[\begin{array}{l}\text{Initial investment + }\\ \text{Salvage value after tax+}\\ \text{Working capital reduction}\end{array}\right]\\ =\$960,000+\left(\$1,500\times \left(1-40\%\right)\right)+\$2,500\\ =\$956,600\end{array}$

Working note (8):

Calculate the salvage value after tax.

$\begin{array}{c}\text{Salvage value after tax = }\left(\begin{array}{l}\text{Salvage value of }\\ \text{new equipment}\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\$12,000\times \left(1-\frac{40}{100}\right)\\ =\$7,200\end{array}$

Working note (9):

Calculate the cash inflow of new equipment each year.

Year	Operating expense after tax (P)(4)	Depreciation expenses after tax (Q) (6)	Salvage value after tax (R) (8)	Net cash inflow $\left(P-Q-R\right)$
2015	($627,000)	$127,987		($499,013)
2016	($627,000)	$170,688		($456,312)
2017	($651,000)	$56,870		($594,130)
2018	($687,000)	$28,454		($658,546)
2019	($687,000)		$7,200	($679,800)

Table (4)

To determine

Calculate the cash flow and net present value (NVP) for buy alternative of Company J.

Explanation of Solution

Calculate the cash flow and net present value (NVP) for buy alternative of Company J as follows:

Year	Cash inflow (10) (A)	Present value factor @12% (B) (11)	Present value $\left(A\times B\right)$
2015	$ -810,000	0.893	-$ 723,330
2016	$ -810,000	0.797	-$ 645,570
2017	$ -842,400	0.712	-$ 599,789
2018	$ -891,000	0.636	-$ 566,676
2019	$ -891,000	0.567	-$ 505,197
Total present value			-$ 3,040,562
Less: Salvage value (11)			-$ 600
Net present value			-$ 3,039,962

Table (5)

Working note (10):

Calculate the cash inflow for each year.

Year 2015:

$\begin{array}{c}\text{Cash inflow = }\left(\begin{array}{l}\text{Number of wates continers}\times \\ \text{Quoted price per continer (1)}\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\left(50,000\times \$27\right)\times \left(1-40\%\right)\\ =\$810,000\end{array}$

Year 2016:

$\begin{array}{c}\text{Cash inflow = }\left(\begin{array}{l}\text{Number of wates continers}\times \\ \text{Quoted price}\text{per continer (1)}\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\left(50,000\times \$27\right)\times \left(1-40\%\right)\\ =\$810,000\end{array}$

Year 2017:

$\begin{array}{c}\text{Cash inflow = }\left(\begin{array}{l}\text{Number of wates continers}\times \\ \text{Quoted price per continer (1)}\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\left(52,000\times \$27\right)\times \left(1-40\%\right)\\ =\$842,400\end{array}$

Year 2018:

$\begin{array}{c}\text{Cash inflow = }\left(\begin{array}{l}\text{Number of wates continers}\times \\ \text{Quoted price per continer (1)}\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\left(55,000\times \$27\right)\times \left(1-40\%\right)\\ =\$891,000\end{array}$

Year 2019:

$\begin{array}{c}\text{Cash inflow = }\left(\begin{array}{l}\text{Number of wates continers}\times \\ \text{Quoted price per continer (1)}\end{array}\right)\times \left(1-\text{Tax rate}\right)\\ =\left(55,000\times \$27\right)\times \left(1-40\%\right)\\ =\$891,000\end{array}$

Working note (11):

Calculate the salvage value after tax for year 2014.

$\begin{array}{c}\text{Salvage value after tax = Salvage value }\times \left(1-\text{Tax rate}\right)\\ =\$1,500\times \left(1-40\%\right)\\ =\$900\end{array}$

To determine

Indicate whether company J should make the containers or buy the containers, and explain the quantitative factors that should be considered for the capital investment analysis.

Explanation of Solution

Indicate whether company J should make the containers or buy the containers, and explain the quantitative factors that should be considered for the capital investment analysis as follows:

In this case, company J should make the containers because make decision ($2,993,203) has less cost than the buy decision ($3,039,662). Qualitative factors of capital investment analysis are,

• Reliability of supplier,
• Quality of the product,
• Stability of purchasing price,
• Labor relations, and
• Community relation.