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, 2006, for $200,000. 

It is now July 1, 2010. 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: 

Direct material.................$0.38 

Direct labour......................0.37 

Variable overhead.............0.17 

Fixed overhead*................0.45 

Total unit cost..................$1.37

* Depreciation accounts for two-thirds of the fixed overhead. The balance is for other fixed overhead costs of the factory that require cash outlays, 60 percent of which would be saved if production of the parts were eliminated. 

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 depreciation 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: 

Direct material...................$0.40 

Direct labour........................0.25 

Variable overhead...............0.08 

Fixed overhead*...................0.60 

Total unit cost.....................$1.33

* The increase in fixed overhead is caused by depreciation on 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?