Toyland Company was one of the original
producers of “Transformers.” An especially complex part of “Sect-a-con”
needs special tools that are not useful for other products. These tools were purchased
on November 16, 2003 for $200,000.
It is now July 1, 2007. The manager of the Transformer Division, Ramona
Ruiz, is contemplating three alternatives. First, she could continue to produce
“Sect-a-con” using the current tools; they will last another five years, at which
time they would have zero terminal value. Second, she could sell the tools for
$30,000 and purchase the parts from an outside supplier for $1.10 each. Third,
she could replace the tools with new, more efficient tools costing $180,000.
Ruiz expects to produce 80,000 units of “Sect-a-con” in each of the next
five years. Manufacturing costs for the part have been as follows, and no change
in costs is expected:

The outside supplier offered the $1.10 price as a once-only offer. It is
unlikely such a low price would be available later. Toyland would also have to
guarantee to purchase at least 70,000 parts for each of the next five years.
The new tools that are available would last for five years with a disposal
value of $40,000 at the end of five years. Tools qualify for CCA at 30 percent
declining balance for tax purposes. Straight-line amortization is used for book
purposes. The sales representative selling the new tools stated, “The new tools
will allow direct labour and variable overhead to be reduced by $0.21 per unit.”
Ruiz thinks this estimate is accurate. However, she also knows that a higher quality
of materials would be necessary with the new tools. She predicts the following
costs with the new tools:

The company has a 40 percent marginal tax rate and requires a 12 percent
after-tax rate of return.
1. Calculate the net present value of each of the three alternatives.
Recognize all applicable tax implications. Which alternative should
Ruiz select?
2. What are some factors besides the net present value that should influence
Ruiz’s selection?

Transcribed Image Text:

Direct material $0.38 Direct labour 0.37 Variable overhead 0.17 Fixed overhead" 0.45 Total unit cost $1.37