Goldsmyth Enterprises (GE) manufactures several different electronic products. The TruSound mini personal earphone, one of GE's principal products, sells for $40 per unit. The Sales Manager for TruSound has stated repeatedly that he could sell more units of this product if they were available. In an attempt to substantiate his claim, the Sales Manager conducted a market research study last year at a cost of $88,000 to determine potential demand for this product. The study indicated that GE could sell 18,000 units of the TruSound product annually for the next five years.

The equipment currently in use has the capacity to produce 11,000 units annually. The variable production costs are $18 per unit. The equipment has a book value of $120,000 and a remaining useful life of five years. The salvage value of the equipment is negligible now and will be zero in five years.

A maximum of 20,000 units could be produced annually on new machinery that can be purchased. The new equipment costs $600,000 and has an estimated useful life of five years with no salvage value at the end of five years. GE's Production Manager has estimated that the new equipment would provide increased production efficiencies that would reduce the variable production costs to $14 per unit.

GE uses straight-line depreciation on all its equipment for tax purposes. The firm is subject to a 40 percent tax rate, and its after-tax cost of capital is 14 percent. The company has been profitable and expects to continue to generate profit.

The TruSound Sales Manager felt so strongly about the need for additional capacity that he attempted an economic justification for the equipment, although this was not one of his responsibilities. His analysis presented below, disappointed him because it did not justify acquiring the equipment.

Purchase price of new equipment: 600,000

Disposal of existing equipment

Loss on Disposal 120,000

Less: tax benefit (40%) (48,000) 72,000

Cost of market research study 88,000

Total Investment 760,000

Contribution Margin from Product

Using new equipment [18,000 x ($40-$14)] 468,000

Using the existing equipment [11,000 x $40] 242,000

Increase in contribution margin 226,000

Less: Depreciation (120,000)

Increase in before tax profit 106,000

Less: Income tax (40%) (42,400)

Increase in profit 63,600

Less: 14% cost of capital on the additional

investment required [0.14 x $760,000] (106,400)

Net annual return of proposed investment

in new equipment (42,800)

GE's Chief Financial Officer perused the calculation of the sales manager and assessed that a number of errors have been made. As the firm's management accountant, the CFO has asked you to revise analysis of this investment proposal.

Required:

1. Prepare corrected calculations for (a) the required investment in the new equipment and (b) the recurring annual cash flows.

2. Compare your analysis in part (1) with the one prepared by the TruSound Sales Manager. For each difference identified, explain why the Sales Manager's version of this calculation was incorrect.

3. Calculate the net present value of the proposed investment in the new equipment.

4. Based on your calculation and case information, do you think GE should invest in the increased capacity?

What other factors should be considered and why?