Case: In December 2004, R. E. Torgler was trying to decide whether to add a new line of injection molded plastic products to those already manufactured and distributed by Reto S.A. In order to do so, the firm would have to buy new injection molding equipment; none of the existing equipment could be adapted to perform the necessary operations, and Torgler was anxious to retain control of manufacturing. Actually, new injection molding equipment of the type needed had been considered before, but a decision to purchase the equipment had been postponed because the product concept was judged to need additional development. But now the products seemed ready.

Sales of the new product were forecast at $2,000,000 per year, from which a sales commission of 15 percent would be paid to Retos sales agents. Direct manufacturing costs were budgeted at $600,000 for materials and $900,000 for labor, leaving an annual cash flow before taxation of $200,000. The new equipment would cost $600,000, delivered and installed, and was expected to have an economic life of 10 years before it would become worthless.

Reto was able to borrow money at 8 percent, although it did not plan to negotiate a loan specifically for the purchase of this equipment.

Questions:

1What kinds of data should Reto SA have collected to develop their sales, cost and cost savings estimates? What sources could they use to get this data?

2What problems would be associated with using the payback period as the decision rule?

3Reto SA has determined their Opportunity Cost of Capital is 12%. Comment on the relevance of the availability of debt at 8% to their decision on this project.