Lesley Donovan is the controller for the East division of Explorer Ltd. Jason

Conner, head of plant engineering, has just left Donovans office after presenting three

alternatives for submission in the capital expenditure budget for the fiscal year 2014. The

budget is due to the CEO in two days and therefore Donovan realizes that time is of the

essence. Conner has outlined the following alternatives to replace an outdated milling

machine: (1) build a general purpose milling machine; (2) buy a special purpose numerically

controlled milling machine; (3) buy a general purpose milling machine.

Explorer Ltd. Is a well-established company. The company was set up about 30

years ago by two brothers Dan and Kevin Thompson, in Huntsville, Ontario, to produce

accessories for the automobile industry. The Central division continues to serve the auto

industry, and is the largest division in the company with sales of $35 million annually. Dans son

is now head of this division. Kevin is still active in the company and is the Chief Executive Officer

(CEO). His office is located in Toronto.

The parts division supplies seals to the mining and petrochemical industry

from a plant in Toronto. This division is only ten years old and until 2010 was highly profitable.

As a result of the downturn in the sector of the economy, sales in 2012 were only $12 million.

The East division, located in Scarborough, is the engineering division. Full time

employees tend to work approximately 2,000 in the division. Regular product lines include

industrial fans, industrial cooling units, and refrigeration units for industrial users. The division

is highly capital-intensive and sales tend to be directly related to general economic conditions.

Each division runs independently and performance is based upon budgeted

return on investment. Bonuses are paid if the budget target is achieved. Annually, each division

prepares a detailed budget submission to Kevin, outlining expected profit performance and

capital expenditure requests. The milling machine proposal is part of the capital expenditure

request.

The 2013 pro forma income statement for East division is set out below:

Sales $22,364,000

Cost of Goods Sold 14,760,240

Gross Profit 7,603,760

Selling and General Administrative Costs 3,578,760

Allocated Costs (based on sales) 1,677,300

Income Before Income Taxes $2,348,220

Return on Sales 10.5%

Return on Investment 8.5%

Investment (Historical Cost) $27,626,118

Jason Connor has pointed out to Donovan that the existing machine is not

only outdated but maintenance costs are becoming prohibitive. Jason also noted that

maintenance costs of new general purpose machines are only $26,000 while special purpose

machines can save an additional $14,000 in maintenance. Also there would be a significant

savings in insurance as the price for a general purpose machine would drop to $3,000 while a

special purpose machine would be 67% higher than the general purpose machine. The machine

has no market or salvage value and he is sure that its book value is now zero. The trouble is that

he doesnt know which proposal is best for the company. In addition to the cost and revenue

date provided, Connor provided comments on each alternative below:

1) Build a general purpose machine:

This machine can be built by East division. The division is below capacity at

present as a major contract has just been completed. The division could thus produce

the machine without affecting revenue-producing activity, but it will take six months to

complete. The machine is expected to last five years and have no salvage value because

removal costs will probably equal selling price.

Connor believes that the division has the technical expertise to undertake the

work. In 2012, the division produced a specialized drilling machine that has proven very

successful. Connor pointed out that David Williams, chief engineer, loves the design

challenge of new machines. Donovan sat down with Connor and produced the following

cost estimates:

Material and parts $55,000

Direct labor (DL$) 90,000

Variable overhead (50% of DL$) 45,000

Fixed overhead (25% of DL$) 22,500

TOTAL $212,500

Donovan argues that this job should also bear a proportion of administrative

costs; she suggests $12,000.

2) Buy a special purpose machine:

The advantage of this special purpose machine is that only one operator is

required and output per hour could increase by 25%. In addition, maintenance costs are

significantly reduced because microchip circuitry is employed.

Connor points out that this machine is state-of-the-art and would probably

mean that new work could be taken on. A numerically controlled machine required

extensive training of operators. In total, 26 weeks are spent in the suppliers factory located

in Florida. While the training is going on, the supplier provides an operator to work the

machine without charge. Expected costs of this training period including hotel, per diem,

and travel will cost $3,000 per week, excluding the operators labor which is set at $15 per

hour.

The machine costs $625,000, and the supplier guarantees the salvage value of

$25,000 at the end of five years. It is available immediately. It is estimated the machine can

generate sales of $243,750 annually at full capacity and require $19,500 in direct materials

cost, which is equivalent to the general purpose machine.

3) Buy a general purpose machine:

The purchase price of this machine is $295,000 and cost levels associated with

the machine are expected to be the same as the general purpose machine built by the

company because the technology is similar. The salvage value of the machine net of

removal costs, is estimated to be $5,000 in five years. It can be delivered immediately.

General comments: The required rate of return for this investment class has been set at 8%

by Kevin Thompson.

Required: Prepare the budget submission to Kevin