P12-14 Strategic Capital Investment Decisions
Smith Electronics manufactures portable CD players. Lillian Perez, the VP of operations at Smith Electronics, is considering a major capital investment decision. It would cost $2,500,000 to put new, highly automated machines in the factory. The equipment would last about 15 years and would have no salvage value at the end of that period. The equipment will replace 10 workers, saving Smith $300,000 per year in direct labor. Operation and maintenance costs on the machines are expected to cost $100,000 per year. The automated equipment is expected to improve quality. Smith's main competitors are installing similar equipment. If Smith installs the equipment, its revenues are expected to remain steady. If Smith chooses not to install new equipment, its contribution margins expected to fall by $200,000 per year as a result of lower quality compared to its competitors. Smith's discount rate is 10% and its tax rate is 30%.
Required
A. How much is Smith expected to save each year if it installs the equipment (including tax effects)?
B. How much will Smith lose each year if it does not install the equipment (including tax effects)?
C. Explain how you would analyze this problem in order to determine if Smith should purchase the new machines.
D. Should Smith purchase the new machine?
E. Assume that programming and maintenance costs turn out to be much higher than Lillian's estimates. However, despite the fact that the automation equipment increased costs, Lillian still wants to continue with the project Explain why Lillian might not want to scrap the equipment.
Searching the net for (dell Inc financial statements for the period of Jan 30 2009) and calculate the following (please show your calculations):
1) Dell Inc EBIT.
2) Dell Inc Profit margin.
3) Dell Inc Current Ratio.
4) Dell Inc Quick Ratio.
5) Dell Inc Return on assets
6) Dell Inc Return on equity.
7) Dell Inc Debt Ratio.
A. To calculate the expected annual savings if Smith installs the equipment, we need to consider the savings from labor costs and the tax effects.
1. Labor cost savings: Smith will save $300,000 per year in direct labor costs by replacing 10 workers.
2. Tax effects: Since Smith has a tax rate of 30%, we need to calculate the tax savings on the labor cost savings. The tax savings would be 30% of $300,000, which is $90,000.
Therefore, the total expected annual savings, including tax effects, would be $300,000 + $90,000 = $390,000.
B. To calculate the annual loss if Smith does not install the equipment, we need to consider the expected contribution margin decrease and the tax effects.
1. Contribution margin decrease: Smith's contribution margins are expected to fall by $200,000 per year if they do not install the equipment.
2. Tax effects: We need to calculate the tax implications of the decrease in contribution margin. Since Smith has a tax rate of 30%, the tax payment would be 30% of $200,000, which is $60,000.
Therefore, the total expected annual loss, including tax effects, would be $200,000 + $60,000 = $260,000.
C. To analyze this problem, we would use a capital budgeting technique called Net Present Value (NPV). NPV helps evaluate the profitability of an investment project by comparing the present value of expected cash inflows and outflows. Here is how to analyze this problem:
1. Calculate the annual net cash flows: To do this, subtract the expected costs (such as operation and maintenance costs) and the savings (such as labor cost savings) from the expected revenues.
2. Determine the required rate of return: In this case, the discount rate provided is 10%. The discount rate represents the minimum return required by the company to undertake the investment.
3. Calculate the present value of the net cash flows: Apply the discount rate to each year's net cash flow to determine its present value.
4. Sum up the present values of all cash flows: Add up the present values of net cash flows to obtain the NPV.
5. Evaluate the NPV: If the NPV is positive, the investment is expected to generate more value than its costs and can be considered attractive. If the NPV is negative, the investment may not be profitable.
6. Consider other qualitative factors: Apart from NPV, you may also consider other factors like strategic importance, competitive advantages, and market conditions.
D. Based on the given information, we do not have the necessary data to calculate the NPV or perform a comprehensive analysis. However, if the NPV is positive, Smith should consider purchasing the new machines as they would generate more value than their costs. If the NPV is negative, it may suggest that the investment is not profitable.
E. Even though the programming and maintenance costs turned out to be higher than Lillian's estimates, she might not want to scrap the equipment due to several reasons:
1. Improved quality: The equipment is expected to improve quality, which may result in higher customer satisfaction and increased market share. This improvement can outweigh the additional costs associated with programming and maintenance.
2. Competitive advantage: Smith's main competitors are also installing similar equipment. If Smith scraps the automation equipment and the competitors continue to use it, Smith may fall behind in terms of cost efficiency and quality.
3. Long-term benefits: The new machines are expected to last 15 years. Lillian may believe that despite the higher costs initially, the long-term benefits and savings in labor costs may still make the investment worthwhile.
4. Adaptability: Lillian may consider that adjustments can be made to optimize programming and maintenance costs over time, making the investment more cost-effective in the long run.