Faddenville Company manufactures several lines of machine products. One unique part, a valve stem, requires specialized tools that need to be replaced. Management has decided that the only alternative to replacing these tools is to acquire the valve stem from an outside source. A supplier is willing to provide the valve stem at a unit sales price of $20 if at least 70,000 units are ordered annually.
The company's average usage of valve stems over the past 3 years has been 80,000 units each year. Expectations are that this volume will remain constant over the next 5 years. Cost records indicate that unit manufacturing costs for the last several years have been as follows:
Direct materials .............................................. $ 3.80
Direct labor ................................................... 3.70
Variable overhead ........................................... 1.70
Fixed overhead .............................................. 4.50
Total unit cost...............................................$13.70
If the specialized tools are purchased, they will cost $2,500,000 and will have a disposal value of $100,000 after their expected economic life of 5 years. Straight-line depreciation is used for financial accounting purposes, but the most accelerated method available under MACRS is used for tax purposes. The specialized tools are considered 3-year property for MACRS purposes. The income tax rate is 40%.
The sales representative for the manufacturer of the new tools states: "The new tools will allow direct labor and variable overhead to be reduced by 80 cents per unit or $1.60 total reduction per unit." Another manufacturer, using identical tools and experiencing similar operating conditions, finds that annual production generally averages 110,000 units. This manufacturer confirms the direct labor and variable overhead savings. However, the manufacturer indicates that it did experience an increase in raw materials cost due to the higher quality of materials that had to be used with the new tools. The manufacturer indicated that its costs have been as follows:
Direct materials .............................................. $4.50
Direct labor .................................................. 3.00
Variable overhead .......................................... .80
Fixed overhead .............................................. 5.00
Total unit cost: ..............................................$13.30
Required:
(1) Determine the annual net after-tax cash inflows available to the company if it purchases the new tools and manufactures the valve stem rather than purchasing the valve stems from the outside supplier. In this case the cash inflows will be from cost savings. (Use the MACRS rate provided in Exhibit 22-4 to compute tax depreciation.)
(2) By how much will the total after-tax cash inflows exceed the initial investment?