The Jonfran Company manufactures three different models of paper shredders. Each has a waste container. Jonfran estimates the following number of waste containers needed over the next 5 years: 2005, 50,000; 2006, 50,000; 2007, 52,000; 2008, 55,000; 2009, 55,000.

Jonfran's current manufacturing costs for waste containers are as follows (based on 50,000 units):

Direct materials $10.00

Direct manufacturing labor 8.00

Variable manufacturing overhead 4.00

Fixed manufacturing overhead

Supervision $100,000

Depreciation on old equipment 150,000

Product and process engineering 40,000

Rent 25,000

General administrative overhead 200,000

Allocation of general plant overhead 35,000

The following additional information is available:

1. The equipment used to manufacture waste containers must be replaced because it has broken. The old equipment is fully depreciated and has a current cash disposal price of $6,500.

2. The new equipment would cost $960,000. The equipment would go into service on January 1, 2005, and would have a 5-year useful life. Under the prevailing tax laws, depreciation is calculated on the double-declining-balance method over the 5 years, with depreciation in the fifth year being the book value of the equipment at the start of that year. The DDB method assumes a zero terminal salvage value at the end of 5 years, but the actual disposal price would be $12,000.

3. An outside supplier has offered to supply all the containers that Jonfran needs over the next 5 years at a fixed price of $29 per container. If the supplier's offer is accepted, Jonfran would not need to replace the equipment.

4. If the waste containers are purchased outside, the salary and benefits of one supervisor, included in the fixed overhead at $45,000, would be eliminated. There would, however, be no change in general administrative overhead.

5. Product and process engineering costs are incurred to ensure that the manufacturing process for waste containers works smoothly. Although these costs are fixed in the short run with respect to units of waste containers produced, they can be saved in the long run if the container is no longer produced. If the waste container is outsourced, product and process engineering costs of $40,000 will be incurred for 2005 but not thereafter.

6. Rent costs of $25,000 are allocated to products on the basis of floor space used for manufacturing the product. If the waste container is discontinued, the space currently used to manufacture it would become available. The company could then use the space for storage and save $10,000 currently paid for outside storage.

7. General plant overhead costs are allocated to each department on the basis of direct manufacturing labor dollars. These costs will not change in total for the company as a whole, but no general plant overhead will be allocated to the waste container if it is no longer produced.

8. Additional working capital is needed to keep the new equipment running efficiently without stoppages. An investment of $50,000 is required at the outset and an additional $15,000 at the end of 2 years. This total is fully recoverable at the end of 5 years.

9. Jonfran has a 40% income tax rate. Its after-tax required rate of return on new equipment is 12%.

Solved Question:

1. On the basis of the net present value criterion, should Jonfran purchase the waste containers from the outside supplier or purchase the new equipment? Prepare a financial analysis. List the assumptions underlying your baseline analysis.

N = Useful Life of equipment in years =5

Double Declining Depreciation Rate=200%*(1/5) = 40%

i=rate of return =MARR=12%=0.12

Present Value(PV) of Cash Flow:(Cash Flow)/((1+i)^N)=

Information 2	A	Cost of New Equipment	$960,000
Information 1 & 9	B	After tax Salvage Value of old equipment	$3,900	(6500*(1-0.4)
Information 8	C	Additional Working Capital	$50,000
	IC D=A-B+C	Initial Outlay	$1,006,100

		Year	1	2	3	4	5
Information 2	A	Beginning Book value (1-0.4=0.6) 0.6^N	$960,000	$576,000	$345,600	$207,360	$124,416
	B	Depreciation Rate	40%	40%	40%	40%
	C=A*B	Annual depreciation	$384,000	$230,400	$138,240	$82,944	$124,416
	D=A-C	Ending Book value	$576,000	$345,600	$207,360	$124,416	$0
	E=C*40%	Depreciation Tax Shield	$153,600	$92,160	$55,296	$33,178	$49,766
Information 2		After tax Salvage Value of New equipment	$7,200	(12000*(1-0.4)

	Purchase the new equipment		2005	2006	2007	2008	2009
	N	Year	0	1	2	3	4	5
	IC	Initial Cash Flow	-$1,006,100
	a	Annual Demand		50,000	50,000	52,000	55,000	55,000
	b=a*($10+$8+$4)	Variable Costs		-$1,100,000	-$1,100,000	-$1,144,000	-$1,210,000	-$1,210,000
		Fixed Costs
Information4	c	Supervision		-$100,000	-$100,000	-$100,000	-$100,000	-$100,000
Information5	d	Product and Process Engineering		-$40,000	-$40,000	-$40,000	-$40,000	-$40,000
Information6	e	Rent		-$25,000	-$25,000	-$25,000	-$25,000	-$25,000
	F=b+c+d+e	Total Annual Cash Flow		-$1,265,000	-$1,265,000	-$1,309,000	-$1,375,000	-$1,375,000
		NOTE:Depreciation on old equipment not required. General and admin overhead and allocated costs are incurred even if the containers are purchased
	W	Working Capital Cash Flows			-$15,000			$65,000
	X	Depreciation Tax Shield		$153,600	$92,160	$55,296	$33,178	$49,766
Information2	Y	After tax Salvage Value of New equipment						$7,200
	CF=IC+F+W+X+Y	Net Cash Flow	-$1,006,100	-$1,111,400	-$1,187,840	-$1,253,704	-$1,341,822	-$1,253,034
	PV=CF/(1.12^N)	Present Value	-$1,006,100	-$992,321	-$946,939	-$892,362	-$852,752	-$711,005
	NPW=Sum of PV	Net Present Worth	-$5,401,479
	1 + rate of return=	1.12	1.12^N=	1.12	1.2544	1.404928	1.57351936	1.76234168
	purchase the waste containers from Outside supplier		2005	2006	2007	2008	2009
	N	Year	0	1	2	3	4	5
Information 1 & 9	IC	Initial Cash Flow (salvage of old equipment)(6500*(1-0.4)	$3,900
	a	Annual Demand		50000	50000	52000	55000	55000
Information 3	b=a*$29	Variable Costs		-$1,450,000	-$1,450,000	-$1,508,000	-$1,595,000	-$1,595,000
		Fixed Costs
Information4	c	Supervision (100000-45000)		-$55,000	-$55,000	-$55,000	-$55,000	-$55,000
Information5	d	Product and Process Engineering		-$40,000
Information6	e	Rent (25000-10000)		-$15,000	-$15,000	-$15,000	-$15,000	-$15,000
	F=b+c+d+e	Total Annual Cash Flow		-$1,560,000	-$1,520,000	-$1,578,000	-$1,665,000	-$1,665,000
	CF=IC+F	Net Cash Flow	$3,900	-$1,560,000	-$1,520,000	-$1,578,000	-$1,665,000	-$1,665,000
	PV=CF/(1.12^N)	Present Value	$3,900	-$1,392,857	-$1,211,735	-$1,123,189	-$1,058,138	-$944,766
	NPW=Sum of PV	Net Present Worth	-$5,726,784

The Net Present Worth of purchasing the new equipment is lower than purchasing the waste container.

The Jonfran should purchase the new equipment.

Required Discussion Questions:

2. Prepare a sensitivity analysis to examine how changes in the assumptions will affect your final computations. For example, you may want to consider (1) changes in tax rates; (2) changes in required rate of return; (3) changes in your prediction on the quantity of waste containers; and (4) any other change you can think of.

3. What non-financial and qualitative factors should Jonfran consider before coming to a decision?