AlRod Enterprises (ARE)

AlRod Enterprises (ARE), is an established manufacturer of microwavable frozen foods. Al Rodriguez is a member of the planning and analysis staff. Al has been asked by Simon Bolivar, chief financial officer of ARE, to prepare a net-present-value analysis for a proposed capital equipment expenditure that should improve the profitability of the western plant. This analysis will be given to the board of directors for approval. Several years ago, as director of planning and analysis at ARE, Simon was instrumental in convincing the board to open the western plant. However, recent competitive pressures have forced all of AREs manufacturing divisions to consider alternatives to improve their market position. To Simons dismay, the western plant may be sold in the near future unless significant improvement in cost control and production efficiency are achieved.

Westerns production manager, an old friend of Simon, has submitted a proposal for the acquisition of an automated-material-handling system. Simon is anxious to have this proposal approved as it will ensure the continuation of the western plant and preserve his friends position. The plan calls for the replacement of a number of forklift trucks and operators with a computer-controlled conveyor belt system that feeds directly into the refrigeration units. This automation would eliminate the need for a number of material handlers and increase the output capacity of the plant. Simon has given this proposal to Al and instructed him to use the following information to prepare his analysis.

Automated-Material-Handling System Projections

Projected useful life.......................................................................................................................... 10 years

Purchase and installation of equipment ............................................................................. $4,500,000

Increased working capital needed* ............................................................................................ $1,000,000

Increased annual operating costs (exclusive of depreciation) ........................................................$200,000

Equipment repairs to maintain production efficiency (end of year 5)............................................$800,000

Increase in annual sales revenue ................................................................................................... $700,000

Reduction in annual manufacturing costs ......................................................................................$500,000

Reduction in annual maintenance costs .........................................................................................$300,000

Estimated salvage value of conveyor belt system ......................................................................... $850,000 *

The working capital will be released at the end of the 10-year useful life of the conveyor belt system

The forklift trucks have a net book value of $500,000 with a remaining useful life of five years and no salvage value for depreciation purposes. If the conveyor belt system is purchased now, these trucks will be sold for $100,000. ARE has a 40 percent tax rate, has chosen the straight-line depreciation method for both book and tax purposes, and uses a 12 percent discount rate. For the purpose of analysis, all tax effects and cash flows from the equipment acquisition and disposal are considered to occur at the time of the transaction while those from operations are considered to occur at the end of each year.

When Al completed his initial analysis, the proposed project appeared quite healthy. However, after investigating equipment similar to that proposed, Al discovered that the estimated salvage value of $850,000 was very optimistic. Information previously provided by several vendors estimates this value to be only $100,000. Al also discovered that industry trade publications considered eight years to be the maximum life of similar conveyor belt systems. As a result, Al prepared a second analysis based on this new information.

Required:

Prepare a net-present-value analysis of the purchase and installation of the material-handling system using the revised estimates obtained by Al Rodriguez. (For this problem, ignore the half-year convention. Assume annual straight-line depreciation of $562,500, which is $4,500,000 divided by 8.)

1. The net present value of the proposed investment:

-

AkRod Enterprises

Net-Present-Value Analysis

Calculation:

Time 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

New equipment

Working capital

Disposition of equipment:

Old forklift trucks

New conveyor belt system

Operating revenue

Operating savings (A)

Tax effect (B)

Total Cash Flow

Discount Factor

Present Value

Net Present Value

$ -

(A) Operating Savings

Operating Savings for Years 1, 2, 3, 4, 6, 7, 8:

Manufacturing cost reduction

Maintenance cost reduction

Increased operating costs

Total

Operating Savings for Year 5:

Manufacturing cost reduction

Maintenance cost reduction

Increased operating costs

Equipment Repairs

Total

(B) Tax Effects

Tax effects - Time 0 - forklift disposal:

Book value

Less: Salvage value

Tax loss

Tax rate

Tax effect (cash inflow/(outflow))

Tax effects - Years 1 through 4:

Revenue

Operating cost savings

Loss of depreciation on forklifts

Depreciation on new equipment

Change in taxable income

Tax rate

Tax effect (cash inflow/(outflow))

Tax effects - Year 5:

Revenue

Operating costs

Loss of depreciation on forklifts

Depreciation on new equipment

Change in taxable income

Tax rate

Tax effect (cash inflow/(outflow))

Tax effects - Years 6 and 7:

Revenue

Operating cost savings

Depreciation on new equipment

Change in taxable income

Tax rate

Tax effect (cash inflow/(outflow))

Tax effects - Year 8:

Revenue

Operating cost savings

Depreciation on new equipment

Salvage value on new equipment

Change in taxable income

Tax rate

Tax effect (cash inflow/(outflow))

.