Goldsmyth Enterprises (GE) manufactures several different electronic products. The TruSound mini personal earphone, one of GEs 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 per cent. 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 to prepare 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.

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 prepare a revised 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 Managers 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?

$ $ 600,000 Purchase price of new equipment Disposal of existing equipment Loss on Disposal Less: tax benefit (40%) 120,000 (48,000) 72,000 Cost of market research study Total Investment $88,000 $760,000 468,000 242,000 Contribution Margin from Product Using new equipment (18,000 x ($40-$14)] Using the existing equipment (11,000 x $40] Increase in contribution margin Less: Depreciation Increase in before tax profit Less: Income tax (40%) Increase in profit Less: 14% cost of capital on the additional investment required [0.14 x $760,000] Net annual return of proposed investment in new equipment 226,000 (120,000) 106,000 (42,400) 63,600 106,400 (42,800)