Microsoft Word - RSM 333 H1S17 - Assignment #1.docx

Problem #2 (10 marks)

Stratcon, is considering which production method it should adopt to complete a 9-year supply contract. As the revenues are already fixed by the contract, the primary issue revolves around cost minimization. After much deliberation, the choice has been narrowed to three options:

• The XAA system requires an upfront capital investment of $3.45 million, incurs monthly expenses of $242,000 (paid at the beginning of each month), and requires $600,000 worth of working capital (fully recovered at the end of the contract). Every 27 months, the entire system must be replaced with no expected salvage value.
• The XBB system requires an upfront capital investment of $5.1 million, incurs quarterly expenses of $1 million (paid at the end of each quarter), and requires $600,000 worth of working capital (fully recovered at the end of the contract). Every 36 months, the entire system must be replaced with an expected salvage value of $1 million.
• The XCC system requires an upfront capital investment of $5.6 million, incurs monthly expenses of $150,000 (paid at the end of each month), and requires $600,000 worth of working capital (fully recovered at the end of the contract). Every 6 months it requires a special additional expense of $200,000 (paid at end of month) and after a total of 18 months, the entire system must be replaced with an expected salvage value of $1.3 million. All three systems use components to which a 30% annual CCA rate applies (2.21% monthly) and the asset pool will remain open after the supply contract under discussion has ended. Stratcon pays a 20% corporate tax rate and will use a monthly discount rate of 1% to evaluate each proposal. Assume taxes are paid when expenses are incurred.

a) The XBB has the largest depreciation tax shields and the longest lifespan. It is the best option available to us. Identify the logical error(s) in this statement and describe the proper method for determining which of the three options creates the most value for Stratcon (2 marks)

b) Which of the three options should Stratcon adopt? Show your supporting calculations (8 marks)