Assignment $-$ Capital Budgeting

Oliver Corp. manufactures gadgets. The end product is produced in different departments within the plant. One component, OC$-100,$ is causing some concern. The component is integral to the production of gadgets but is readily available in the marketplace. The machine used to produce the component is nearing the end of its useful life and management is trying to decide whether to replace it or outsource the supply.

The current costs related to the OC$-100$ are as follows:

The plant can produce $200,000$ units per year. It needs $180,000$ units of OC$-100$ for gadget production and sells the remaining $20,000$ units externally at a price of $$150\mathrm{.}00.$ It incurs variable selling costs of $$35\mathrm{.}00$ per unit when it sells OC$-100$ externally. Their policy is to fulfil internal requirements first, then sell OC$-100$ externally.

A supplier has approached Oliver with a proposal to produce OC$-100$ for them. The cost would be $$120\mathrm{.}00$ per unit. The supplier guarantees on$-$time delivery and has agreed to a penalty of $25\%$ of revenue on any late shipments. The company can supply up to $250,000$ units per year and has guaranteed the price of $$120\mathrm{.}00$ for the entire five$-$year contract.

Oliver can purchase a new machine to replace the existing equipment used to produce OC$-100$ for $$6,500,000.$ It is anticipated the new machine will result in direct material cost savings of $10\%$ and a direct labour cost savings of $15\%$ but it is anticipated that variable overhead will increase by $5\%.$ The new machine's useful life is expected to be $5$ years and its residual value at that time will be $$180,000.$ It will be classified as a class $8$ asset for tax purposes, with a CCA of $20\%.$ The capacity of this new machine will be $250,000$ units per year. The corporate tax rate is $40\%$ and the company requires a $15\%$ return on this investment.

Oliver's marketing research group has determined the anticipated demand for gadgets

$1$

and the OC$-100$ external sales demand over the next $5$ years. The results are below.

$\backslash$table$[[$Estimated Product Demand$],[,$Year $1,$Year $2,$Year $3,$Year $4,$Year $5,],[$Gadget demand,$190,000,200,000,205,000,210,000,220,000,],[$OC$-100$ demand,$60,000,65,000,65,000,70,000,75,000,]]$

Management estimates that $70\%$ of the supervisory costs and $$300,000$ of general administration expenses would be eliminated if the OC$-100$ were outsourced.

Management also feels that there will need to be modifications to the design of the OC$100$ in future years in order for the gadget to remain competitive. The machine's manufacturer has assured Oliver management that the changes will be possible at virtually no change in cost$.$ The external supplier has indicated that any design changes would incur additional costs for Oliver.

Required:

Assume that you have been hired by Oliver Inc. to determine whether the company should buy the new machine or outsource production of OC$-100.$ Prepare a quantitative analysis, and evaluate any qualitative factors that will be relevant to the decision.

Provide a recommendation for management.