Equipment replacement, income taxes, unequal project lives, ethics. (CMA, adapted)

Instant Dinners, Inc. (IDI) makes microwaveable frozen foods. The company is considering purchasing an automated materials-movement system (AMMS) for its Western Plant. Bill Rolland, IDEs chieffinancial officer, has asked Lealand Forrest, assistant controller, to prepare a net present value analysis for the proposal.

Rolland was instrumental in convincing the board of directors to open the Western Plant.

Now, unless significant improvements in cost control and production efficiency are achieved, the Western Plant may be sold. Rolland is anxious to have the Western Plant continue to oper¬

ate to maintain his credibility with the board and also to help Western’s production manager, a longtime friend ofRolland.

The AMMS would replace a number of forklift trucks, eliminate the need for a number ofmaterials-handlers, and increase the output capacity of the Western plant.

Rolland has given Forrest the following information regarding the AMMS investment for the net present value analysis:

Projected useful life 10 years Purchase/installation $5,280,000 Increased working capital needed 1 200 000 Increased annual operating costs (excluding amortization)

over current costs 240 000 Reduction in annual manufacturing costs over current costs 480,000 Reduction in annual maintenance costs over current costs 360 000 Increase in cash flow from higher sales revenue 840 000 Estimated disposal price at end of useful life \ Q20 000 Estimated recovery ofworking capital at end of useful life 1,200,000 IDI uses straight-line amortization for financial reporting purposes for all its equipment assuming a zero terminal disposal price. The forklift trucks have a net book value of $576,000 with a remaining useful life of eight years and a zero terminal disposal price. If IDI purchases AMMS now, it can sell the forklift trucks for $120,000. To make the ten-year project life of AMMS comparable to that of the forklift alternative, Forrest estimates that if IDI does not buy the AMMS, the company will lease new forklift trucks for the Western Plant for years 9 and 10 at a cost of $96,000 each year.

IDI has a 40% tax rate and requires a 12% after-tax rate of return on this project.

Assume that tax effects and cash flows from equipment acquisition and disposal occur at the time of the transaction and that tax effects and cash flows from operations occur at the end of each year. The equipment qualifies for a 30% declining balance capital cost allowance rate.

Rolland was pleased with Forrest’s initial analysis. After the initial analysis was com¬

pleted, Forrest discovered that the estimated terminal disposal price of the AMM$ should be

$120,000, not $1,020,000, and that the useful life of the system was expected to be eight years, not ten years. Forrest prepared a revised, second analysis based on this new informa¬

tion. On seeing the second analysis, Rolland told Forrest to discard the revised analysis and not to discuss it with anyone at IDI or with the board of directors.

Instructions Form groups of three students to complete the following requirements.

Required 1. What is the net present value of the decision to replace forklifts with the AMM$ based on the original estimates Rolland gave to Forrest?

2. Using net present value analysis, determine whether IDI should purchase and install the AMMS on the basis of the revised estimates that Forrest obtained.

3. Explain how Forrest, a management accountant, should evaluate Rolland’s directives to conceal the revised analysis.

4. Identify the specific steps Forrest should take to resolve this situation.