Case in Finance XYZ Company

XYZ Limited is a manufacturer of transmissions and axles used in the harvesting equipment of the agricultural industry. The manufacturing process is quite extensive, resulting in a vast amount of bulky steel scrap. The unprocessed steel scrap is sold as a by-product of the manufacturing operation to various firms involved in the recycling process.

The executive committee is currently evaluating whether to process the scrap into different grades and types of usable steel. Using various models of chip crushers, the scrap can be ground and compressed into either rough or fine scrap. The fine scrap would fetch a higher market price than the rough scrap. XYZ Limited has to decide whether to invest in the higher-cost chip crusher (HCC) to produce fine scrap or the lower-cost chip crusher (LCC) to produce rough scrap.

As a financial analyst of the company, you have gathered relevant purchase prices and operating costs of the two chip crushers from the supplier of the chip crushers and the marketing and production staff. The key estimates of financial data for the two machines are given below:LCC HCC Purchase Price $400,000 $480,000 Useful Life (years) 4 6 Depreciation (reducing balance method) 40% p.a. 30% p.a. Salvage value at the end of useful life $80,000 $48,000 Annual interest expense $48,000 $48,000 Annual scrap revenue $450,000 $600,000 Annual operating costs:- Variable overheads $50,000 $150,000 - Salaries $80,000 $110,000 - Marketing $45,000 $60,000

The calculation for annual operating costs includes the following items:

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a) Variable overheads are direct operating expenses incurred in the production of the fine or rough scrap. b) Salaries represent the costs of employing two new machine operators at a salary of $40,000 per annum each. For the HCC machine, the company will only need to employ a new machine operator and the second, who earns $70,000 per annum, will be transferred from the axle assembly plant. The second operator from the main plant would otherwise have been made redundant with a redundancy payment of $50,000. c) The marketing cost is based on the standard allocation of the new investment towards group advertising expenses, which is 10% of annual revenue. It has been estimated that the additional group advertising required to promote the sales of fine or rough scrap is only $40,000 per year.

The accountant, Mr. Smith pointed out to you that the revenue figures do not take into consideration the scrap sales that XYZ would generate regardless of whether the company bought either machine. He has estimated that the current unprocessed scrap would generate a net income of $50,000 per year.

Production facilities for the steel scrap would be set up in an unused section of XYZ Limited main plant. The section of the plant where the steel scrap production would occur has been unused for several years and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, XYZ Limited spent $80,000 to rehabilitate that section of the main plant. Mr. Smith believes this outlay, which has already been paid and expensed for tax purposes, should be charged to the steel scrap project. His contention is that if the rehabilitation had not taken place, the firm would have to spend $50,000 to make the site suitable for the steel scrap project. As the section of the plant has been rehabilitated, it could fetch a rental income of $40,000 per year.

The company's nominal cost of capital is 15 percent per annum. Assume that the company is subject to 30% corporate tax and that the tax is paid at end of the same year (i.e. not the following year).

My only question is:

Clearly state the assumptions with justification, undertake research to identify the qualitative factors considered in recommending LCC or HCC?