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The Wood Pellet Corporation ( WPC ) is considering opportunities to modernize ( automate ) its plant and equipment. Rachelle Brown, the president of the
The Wood Pellet Corporation WPC is considering opportunities to modernize automate its plant and equipment. Rachelle Brown, the president of the firm, is enthusiastic about an automation strategy and sees it as essential if the firm is to stay competitive.
As a first step in the economic analysis of automated equipment, a cashflow net present value calculation was done for one of the more desirable pieces of equipment. The firm conventionally uses to evaluate investment opportunities debt currently costs before tax The statutory corporate tax rate is
Exhibit shows the capital budgeting analysis for the $ investment. The entire amount of investment is eligible for a investment tax credit. The tax basis of the investment is $$ minus half of the $ investment tax credit The estimated life of the equipment is five years with zero salvage value at the end of that period of time. The firm uses the accelerated cost recovery system method of equipment writeoff for taxes shown in Table Links to an external site.
The equipment will save $ of labor costs per year. It will have a capacity of units per year. These cost and capacity figures are based on solid information and can be relied on to be correct.
Rachelle accepts the cashflow assumptions that result in the $ negative net present value, as shown in Table Links to an external site. But she is bothered by the longrun consequences of rejecting the investment. She knows that the firm must modernize if it is to stay competitive. Rachelle also thinks it essential that any investment enhance the financial position of the stockholders. The negative net present value is disconcerting.
Table Capital budget analysis, $ million investment
There are several other factors not directly incorporated into the cashflow analysis. The investment will increase the quality of the output. The product will be more consistent in its characteristics and thus more attractive to the purchasers. The economic value of this characteristic was thought to be too difficult to measure and was not included its inclusion would have decreased the reliability of the cash flow measures used
Moreover, the investment would increase the firms productive capacity by percent. With this increased capacity, the firm could react more rapidly to new orders and deliver goods straight from production rather than from inventory. It is estimated that the average inventory carried during a year could be reduced by $ The annual aftertax cost of carrying inventory is estimated to be of the investment.
A third advantage of the new equipment is that it is more reliable and has less down time than the present equipment. This would improve the ability to service customers as well as reduce inventories this factor did affect the estimated $ inventory cost reduction
The product line that the equipment would produce is currently earning $ of cash flow per year.
The equipment being considered is a departure from the equipment used in the past. While it is felt that the fiveyear life estimate is reasonable, it is also felt that a new generation of this type of equipment will be forthcoming after five years. It is estimated that, if the current investment is made, $ of future cost savings per year are feasible with improved versions of the equipment.
Question:
What is your recommendation regarding the investment?
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