2. Domco manufactures small gasoline engines for the home gardening

power tool industry. Their production line for 8hp engines is very labor intensive. The company has an opportunity to produce 8hp engines for all of Sears Craftsman small garden power products that require an 8 horsepower rating.

In order to increase production Domco will have to install a new automated production line. The engineering estimate for the cost of the new production facility is $12,500,000. If the new production line is installed, it is estimated that Domco will save $1,000,000 per year in direct labor cost. All other variable cost per unit will remain the same.

The Sears contract is for 5 years and will be renewed at the end of that time if both parties agree. The Sears contract will increase sales in 8hp engines by 30% per year. The current sales price per engine is $48 with a total volume of 800,000 units sold per year.

Variable cost amount to 32% of the sales price per engine exclusive of direct labor cost. If the new production line is installed the old production line will be dismantled and scraped (sold) for $45,000 and will have a realize loss for tax purposes of $280,000. If the old line were not sold today it could be sold for $25,000 at the end of its life in five years.

The old production line was put into servers 10 years ago at a cost of $975,000 and was being depreciate over a 15 year life using straight line depreciation without taking salvage value into consideration. The new production line will be depreciated over 5 years using straight line depreciation without taking salvage value into consideration.

If Domco goes ahead with the project, the company will use funds currently available to pay for the new line. The new production line can be scraped (sold) for $175,000 five years from today. Since no salvage value has been use in the depreciation calculation for the equipment the entire amount a taxable gain.