2010 CMA Part 2
Section D – Capital Budgeting
Sandi Tool & Die
Estimated time 40 minutes
Sandi Tool & Die Company has been in business profitably for over 20 years serving primarily the
aerospace industry in southern California. Miranda Casey, Sandi's president, is concerned about the
age and effectiveness of some of the manufacturing equipment in one of Sandi's divisions. She is
currently considering the replacement of a lathe and a milling machine with one machine, a
numerically controlled, computer-integrated manufacturing (CIM) unit.
The lathe and milling machine have a combined net book value of $20,000 and a current salvage
value of $15,000. Both machines are fully depreciated for income tax reporting purposes. The
remaining useful lives of the lathe and milling machine are 6 years. The company uses straight-line
depreciation, and the machines have a combined salvage value of $2,000 at the end of six years.
The new CIM unit will cost $180,000 to purchase plus an additional $10,000 to install and test. This
machine would have a six-year life for financial statement reporting purposes but would be
depreciated using the Modified Accelerated Cost Recovery System (MACRS) for five-year property for
income tax reporting purposes (see table below). At the end of 6 years, the expected book value and
salvage value of the CIM unit will be $16,000.
MACRS rates for
Five-year Property Class
20.00%
32.00
19.20
11.52
11.52
5.76
Year
1
2
3
4
5
6
It is expected that savings in operating expenses will be $20,000 per year if the CIM unit is
purchased. It is also expected that the additional contribution margin from added business because of
the increased quality of machine part output from the CIM unit will increase $30,000 per year.
Sandi uses an after-tax hurdle rate of 10 percent and has an effective income tax rate of 40 percent.
Assume that the initial purchase amounts and current salvage value transactions will occur on
January 1, 2010. Assume that all other cash flows occur at year end for income tax reporting
purposes. Listed below are the discount factors at 10 percent.
Period
1
2
3
4
5
6
Present Value
Present Value of an
of $1
.909
.826
.751
.683
.621
.564
Ordinary Annuity of $ 1
0.909
1.736
2.487
3.170
3.791
4.355
Required:
A. 1. Determine the net cash flows for each year of the life of the CIM unit if it is purchased.
Round amounts to the nearest dollar.
2. Determine the net present value of this decision if the CIM unit is purchased. Round
amounts to the nearest dollar.
3. Should Sandi Tool & Die Company makes the investment in the CIM unit? Explain
reasoning.
B. List at least four business factors, other than net present value, that Miranda Casey should
consider in deciding whether or not to replace the lathe and milling machine with the CIM
unit.
2010 CMA Part 2
Section D – Capital Budgeting
Sandi Tool & Die
Solution
A.
1. and 2. The net cash flows and net present value of the decision to purchase the computerintegrated manufacturing (CIM) unit are as follows.
Year 0
Salvage value, old machine
Tax effect on salvage at
40%
Net salvage, old
CIM purchase
CIM install and test
Investment/Depreciation
base
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
$15,000
($2,000)
(6,000)
800
9,000
(1,200)
(180,000)
(10,000)
(190,000)
Salvage value, CIM
Tax effect on salvage at
40%
Net salvage, CIM
16,000
(6,400)
9,600
MACRS rates
MACRS depreciation
Tax savings at 40%
0.2000
$38,000
$15,200
0.3200
$60,800
$24,320
0.1920
$36,480
$14,592
0.1152
$21,888
$8,755
0.1152
$21,888
$8,755
0.0576
$10,944
$4,378
Operating expense savings
Added contribution margin
Additional taxable income
Less taxes at 40%
Cash flow from operations
________
20,000
30,000
50,000
(20,000)
30,000
20,000
30,000
50,000
(20,000)
30,000
20,000
30,000
50,000
(20,000)
30,000
20,000
30,000
50,000
(20,000)
30,000
20,000
30,000
50,000
(20,000)
30,000
20,000
30,000
50,000
(20,000)
30,000
Net cash flows
($181,000)
$45,200
$54,320
$44,592
$38,755
$38,755
$42,778
0.909
$41,087
0.826
$44,868
0.751
$33,486
0.683
$26,470
0.621
$24,067
0.564
$24,127
Present value factors
Present value cash flows
Net present value
1.000
($181,000)
$13,108
3. Sandi Tool & Die Company should make the investment in the CIM unit because the net
present value is a positive $13,108. Since the net present value is positive, the project has a
rate of return higher than the hurdle rate of ten percent.
B.
At least four business factors, other than net present value, that Miranda Casey should consider
in deciding whether or not to replace the lathe and milling machine with the CIM unit include the
following.
•
Reduced cycle times through flexibility in changing setups and length of production runs to meet
customer needs.
•
Assess what competitors are doing regarding production capability and the impact of the CIM
unit on Sandi's competitiveness.
•
Availability of employees with skills to program and maintain the new CIM unit, and other retraining needs and capabilities.
•
Increased operating leverage and risk due to higher fixed costs.