Claude Marchand, the manager of Homestead Products, a wholly owned division of Crosslink Inc., has asked Thandie Ng, the management accountant, to analyze the possibility of introducing a new product referenced as CL2009-6. Through the years the company has found that its products have a useful life of six years, after which the product is dropped and replaced by another new product.
Marchand is trying to decide whether to launch the product. He is particularly excited about this proposal, because it calls for producing the product in the company's old plant at Kelowna, Marchand's home town. During the last recession, Crosslink had to shut down this plant and lay off its workers, many of whom had grown up with Marchand and were his friends. Marchand had been very upset when the plant was closed down. If CL2009-6 were produced in the new plant, most of the laid-off workers would be rehired.
Ng gathers the following data:
a. CL2009-6 will require new special-purpose equipment costing $1,275,000. The useful life of the equipment is six years, with a $360,000 estimated terminal disposal price at that time.
The equipment qualifies for a capital cost allowance rate of 25%, declining balance.
b. The old plant has a book value of $300,000 and is being amortized for accounting pur poses on a straight-line basis at $30,000 annually. The plant is currently being leased to another company. This lease has six years remaining at an annual rental of $60,000. The lease contains a cancellation clause whereby the landlord can obtain immediate posses sion of the premises upon payment of $42,000 cash (fully deductible for income tax purposes).
c. Certain nonrecurring market research studies and sales promotion activities will amount to a cost of $375,000 at the end of year 1. The entire amount is deductible in full for income tax purposes in the year of expenditure.
d. Additions to working capital will require $260,000 at the outset and an additional $240,000 at the end of two years. This total is fully recoverable at the end of six years.
e. Net cash inflow from operations before amortization and income taxes is expected to be $480,000 in years 1 and 2, $720,000 in years 3 to 5, and $400,000 in year 6. The after-tax required rate of return is 12%. The income tax rate is 36%.
REQUIRED
1. Use a net present value analysis to determine whether Ng should recommend launching CL2009-6.
2. Ng subsequently learns that the new special-purpose equipment required to make CL2009-6 may only be available at a cost of $1.68 million. All other data would remain unchanged. He revises his analysis and presents it to Marchand. Marchand is very unhappy with what he sees. He tells Ng, "Try different assumptions and redo your analy sis. I have no doubt that this project should be worth pursuing on financial grounds."
Ng is aware of Marchand's interest in supporting his hometown community. There is also the possibility that Marchand may be hired as a consultant by the new plant management after he retires next year. Why is Marchand unhappy with Ng's revised analysis? How should Ng respond to Marchand's suggestions? Identify the specific steps that Ng should take to resolve this situation.