BUSI $354$

Assignment $-$ Capital Budgeting

Santana Inc. manufactures widgets. The end product is produced in different

departments within the plant. One component, $C1,$ is causing some concern.

The component is integral to the production of widaote.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 manufacturing costs of the $C1$ are as follows:

The plant can produce $100,000$ units per year. It needs $65,000$ units of $C1$ for

widget production and sells $20,000$ units externally at a price of $$71\mathrm{.}00.$ It incurs

variable selling costs of $$4\mathrm{.}00$ per unit when it sells $C1$ externally. Their policy is

to fulfil internal requirements first, then sell C$1$ externally.

Pluto Corporation has approached Santana with a proposal to produce $C1$ for

them. The cost would be $$69\mathrm{.}00$ per unit. Pluto guarantees on$-$time delivery and

has agreed to a penalty of $25\%$ of revenue on any late shipments. Pluto has

further agreed to provide up to $90,000$ units per year and has guaranteed the

price of $$69\mathrm{.}00$ for the entire fivestract.

Santana can purchase a new machine to replace the existing equipment used to

produce C$1$ for $$4,600,000.$ It is anticipated the new machine will result in labour

cost savings of $10\%.$ All other costs will remain the same. The new machine's

useful life is expected to be $5$ years and its residual value at that time will be

$$150,000.$ 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 $100,000$ units per year. The

corporate tax rate is $40\%$ and the company requires a $10\%$ return, after tax, on

this investment.

Management of Santana asked its marketing research group to determine the

anticipated demand for widgets over the next $5$ years. Management also asked

the group to determine whether the excess capacity could be used to produce C$1$

for external sales.

The marketing group reported the following information:

Demand for widgets will be approximately $65,000$ per year for the next

three ware.and will increase to $70,000$ in years $4$ and $5.$

The company expects external sales will be $18,000$ units per year for

the first three years and will increase to $25,000$ units per year for the

last two years.

Management estimates that $40\%$ of the supervisory costs and $$100,000$ of

general administration expenses would be eliminated if the C$1$ were outsourced.

Management also feels that there will need to be modifications to the design of

the C$1$ in future years in orderfor the widget to remain competitive. The

machine's manufacturer has assured Santana management that the changes will

be possible at virtually no change in cost$.$ Pluto Corporation has indicated that

any design changes would incur additional costs for Santana.

Required:

Assume that you have been hired by Santana Inc. to determine whether the

company should buy the new machine or outsource production of C$1.$ Prepare a

quantitative amalveic.and evaluate any qualitative factors that will be relevant to

the decision. Provide a recommendation for management.