13. new product with investment and inventory Ralph is now trying to decide whether to accept a customer’s proposal to sign a long-term supplier contract. The customer will require 1,000 or 3,000 units of a specialized assembly in each of the next 3 years.

The three periods are independent, and the probability of 1,000 units being required is .5 in each period. (Thus, the expected number of units is 2,000 each period.) The customer is willing to pay an upfront retainer of 90,000, plus 100 per unit ordered and delivered. The customer, though, determines the amount required (resulting in the noted probabilities)

Ralph’s cost analysis reveals direct material will cost 32 per unit and direct labor will cost 18 per unit. Overhead is costed at a full cost rate of 150% of material plus 50% of direct labor. Half of each rate is regarded as variable. Ralph’s marginal tax rate is 42% in each period. Ralph is working below capacity and has under-absorbed overhead (our plug in Chapter 6) that is being expensed for tax purposes.

This situation is expected to persist for at least 4 more years.

(Notice that the retainer of 90,000 will be booked as revenue, both for financial and tax purposes, during the period of production. A reasonable assumption is 1/3 is booked at the end of each of the 3 production periods.) Ralph must also acquire a specialized machine in order to manufacture this assembly. The machine can be acquired for 125,000. It will have zero salvage value at the end of the contract, and will be depreciated for tax purposes on a 3-year MACRS basis

(33.33%, 44.45%, 14.81%, 7.41%). In addition, Ralph would be forced to maintain an inventory of 500 units, which would be depleted in the third year. Thus, if the customer orders 1,000 units in the first year, 1,500 will be produced in the first year. If 3,000 units are ordered in the first year, 3,500 will be produced in the first year. Production in the third year will be actual demand less 500 units. (Assume the machine depreciation will be treated as a period cost for tax purposes.)

For planning purposes, Ralph has decided to ignore estimated tax payments and intraperiod cash flow timing differences. Thus cash flow associated with production occurs at the end of the production year, tax payments occur at the end of the year in question, and so on. This is not accurate, but it is the way Ralph has decided to take an initial cut at the problem. Suppose Ralph is risk neutral and discounts after tax cash flow at a rate of 9%. Should Ralph accept the customer’s proposal?