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Manufacturing manufactures
components for the farming industry and is considering
replacing its existing equipment with new and more
high technology machinery, despite the fact that
its existing eq
uipment is only a few years old and still working well.
The existing machinery will be fully depreciated in 5 years time but will have
sufficient machine
hours left to remain functioning for
15 years. If
new equipment, the old
machinery could be disposed of for $2,500,000
The new equipment would cost $65,000,000 and for tax purposes it would fall into
a declining
balance CCA class. To stimulate the economy, the rece
nt budget stipulates that for year 1 the CCA
rate would be 45%, reducing to 40% in year 2, and then returning to 30% thereafter. This equipment
would have a useful life of 10 years, after which it is expected to be disposed of for proceeds of
o make this new machinery operate, customized software totaling $10,000,000 would be purchased.
Unlike the machinery, for tax purposes this equipment would fall into a straight
line CCA
class over
a 5 year period.
The new equipment will enable
to i
mmediately reduce its Work In Process on the factory floor
by $1,500,000. However to support sales, it is expected that receivable will need to increase by
$6,000,000 at he start of the first year and by another $2,000,000 at the end of year 6
The Annual
fixed costs for the new system will be $7,500,000
Management believe that they have little choice but to move forward with the new equipment
as they are convinced their competitors will bring out a product that will reduce their current annual
me from 200,000 units to 175,000 if they do not follow suit with a similar high quality product
that can
be made with the new equipment.
The current product sells for $500 per unit and given the expected competitive response, it is
expected the price
will not be able to be increased for the new higher quality product manufactured
with the new machinery.
Selected data for the existing product include:
$ per #
Selling price per unit
Direct material cost per unit
Direct labour cost per
Variable overhead cost per unit
Fixed overhead per unit
Gross margin per unit
It is expected that once the new machinery is installed, savings will occur with a reduction in the cost
of direct materials by $15 per un
it. In addition, direct labour will be reduced by 20% and variable
overhead by 10%. The existing fixed costs include $4 per unit of depreciation.
Manufacturing has a 40% income tax rate and its
weighted average
cost of capital is 12%.
Calculate t
he ne
t present value of this project, and recommend to management if the project should
be accepted.
be sure to consider the change in incremental cash fixed costs

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