make with respect to s tives that exist. Income tax effects she C10-3 Capital Project Analysis (ICAO) Joan Staines is the controller of the Tage division of Canam Enterprises Led William Chu, head of plant engineering, has just left Stainess oface after present ing to her three alternatives for submission in the capital expenditure budget ent the fiscal year 2011. The budget is due in Windsor in two days and therefore Staines realizes that time is of the essence. Chu has outlined the following alternatives to replace an outdated milling machine: (1) build a general-purpose milling machine; (2) buy a special-purpos numerically controlled milling machine; (3) buy a general-purpose milling machine. Chu has stated that Tage does not have the expertise to build a numer; cally controlled milling machine. BACKGROUND Canam Enterprises Ltd. is a well-established company. The company was set up about 25 years ago by brothers Al and Steve Jablonski, in windsor, Ontario, to pro duce accessories for the automobile industry. The Alpha division continues to sero the auto industry, and is the largest division in the company, with sales of $35 mive lion annually. Al's son now heads this division. Steve is still active in the company and is the chief executive officer (CEO). His office is located in the Alpha division's Windsor factory. The Monte division supplies seals to the mining and petrochemical industry from a plant in Toronto. This division is only 10 years old and until 2007 was highly profitable. As a result of the downturn in this sector of the economy, sales in 2009 were only $12 million. The Tage division, located in Scarborough, is the engineering division. Regular product lines include industrial fans, industrial cooling units, and refrigera tion units for industrial uses. The division is highly capital-intensive and sales tend to be directly related to general economic conditions. Each division is run 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 Steve, outlining expected profit performance and capital expenditure requests. The milling machine proposal is part of the capital expenditure request. The 2010 pro forma income statement for Tage 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 Allocated costs (based on sales) 3, 578, 240 1,677,300 Income before income taxes 5, 255, 540 Return on sales $ 2, 348, 220 Return on investment 10.5% Investment (historical cost) 8.5% $27,626, 118 THE PROPOSED PURCHASE Chu has pointed out to Staines that not only is the existing machine outdated but maintenance costs are becoming prohibitive. The machine has no market or salvage value and he is sure that its book value is now zero. The trouble is that he doesn't know which proposal is best for the company. In addition to the cost and revenue data provided in Exhibit 10A-1, Chu provided comments on each alternative. 1. Build a general-purpose machine. This machine can be built by the Tage divi- sion. The division is below capacity at present because a major contract has just been completed. The division could thus produce the machine without affecting revenue-producing activity, but it will take six months to complete. The machine is expected to last five years and have no salvage value because removal costs will probably equal selling price.Iterna- Chu believes that the division has the technical expertise to undertake the work. In 2009, the division produced a specialized drilling machine that has proven Wery successful. Chu pointed out that David Williams, chief engineer, loves the design challenge of new machines. Staines sat down with Chu and produced the following cost estimates: sent- for Material and parts Direct labour (DL$) $ 55,000 Variable overhead (50% of DL$) 90,000 ng Fixed overhead (25% of DL$) 45,000 SA 22,500 $212,500 eri- Staines argues that this job should also bear a proportion of administrative costs; she suggests $12, p 2. Buy a special-purpose machine. The advantage of the special-purpose machine is pro- that only one operator is required and output per hour could increase by 25 per- ierve cent. In addition, maintenance costs are significantly reduced because microchip il- circuitry is employed. Chu points out that this machine is state-of-the-art and would probably mean on's that new work could be taken on. A numerically controlled machine requires exten- sive training of operators. In total, 26 weeks are spent in the supplier's factory located in Minneapolis. While the training is going on, the supplier provides an operator to work the machine without charge. Expected costs of this training in period, including hotel, per diem, and travel are $3,000 per week, excluding the operator's labour. The machine costs $625,000, and the supplier guarantees the salvage value of ra- $25,000 at the end of five years. It is available immediately. d 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 gen- eral-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 percent by Steve Jablonski. REQUIRED Prepare a budget submission to Jablonski outlining the qualitative and quantitative analysis required. Ignore income taxes. Outline the assumptions you have employed and your recommended course of action. EXHIBIT 10A-1 Cost and Revenue Data on an Annual Basis* General Purpose Equipment Special Purpose $20,000 $20,000 Supervisor Operators - required $15.00/hour $15.00/hour - wages and benefits $3,000 $5,000 Insurance $26,000 $12,000 Maintenance $243, 750 Capacity (sales) $195,000 Direct materials $19,500 $19,500 50% of DL$ Variable overhead 50% of DL$ 25% of DL$ 25% of DL$ Fixed overhead (including depreciation) years 5 years Depreciation method straight line straight line Capital Budgeting Decisions 43 Assumes single-shift operation will continue