Ray Summers Company operates at full capacity of 12 298 units per yeer. The comp

Question

Ray Summers Company operates at full capacity of 12 298 units per yeer. The company, however, is atill unable to fully meet the demand for its product, estimated at 15,000 units annually. This level of demand is expected to continue for at least another four years. To meet the demand, the firm is considering the purchase of new equipment for $580,000. This equipment has an estimated useful life of 4 years; estimated sales (disposal) value of this asset at the end of 4 years is $50,000 (pretax). The engineering division estimates that installing, testing, and training for the use of the equipment will cost $12.000. These costs are to be capitalized as part of the cost of the new equipment An adjacent vacant warehouse can be leased for the duration of the project for $10,000 per year, which cost would be included as part of fixed manufacturing overhead. The warehouse needs $58,000 of renovations to make it suitable for manufacturing. The renovation cost is to be capitalized as part of the cost of the new equipment The lease terms call for restoring the warehouse to its original condition at the end of the lease. The restoration is estimated to cost $20,000, a cost that is fully deductible for tax purposes. Current pretax operating profit per unit is as follows: s 370 Manufacturing Marketing $111 37 $148 Fixed costs: Manuf Marketing and administrative 15 4e 188 s 182 Operating profit before tax The new equipment would have no effect on the variable costs per unit All current fixed costs are expected to continue with the same total emount. The per-unit fixed cost includes depreciation expenses of S5 for manufacturing and $4 for marketing and administration. Additional fixed manufacturino costs of $140000 exctidion di ciat on on the new eainment) will he incurredt each vear if the arch

Explanation / Answer

1 Net Initial investment outlay year0: A Cost of equipment $580,000 B Installation,testing & training $12,000 C Renovation $58,000 D=A+B+C Net initial outlay in year 0 $650,000 2a Incremental after tax operating profit in year 1 through3 E Sales price per unit $378 F Variable cost per unit $148 G=E-F Unit contribution margin $230 H Increase in quantity of production 2702 (15000-12298) I=G*H Increase in contribution margin $621,460 J Increase in fixed manufacturing cost(excluding depreciation) $140,000 K Increase in fixed Marketing cost $100,000 L Lease of ware house $10,000 M Annual depreciation of initial capital $           150,000 (650000-50000)/4 P=J+K+L+M Total increase in fixed costs $400,000 Q=I-P Increase in before tax profit $221,460 R=Q*(1-0.4) Incremetal after tax operating profit in year 1 through 3 $132,876 Incremental after tax operating profit in year 4 Q Increase in before tax profit from year1 to3 $221,460 S Restoration cost of warehouse in year4 $20,000 T=Q-S Increase in before tax profit in year4 $201,460 U=T*(1-0.4) Incremetal after tax operating profit in year 4 $120,876 3a Incremetal after tax cash inflow in year 1 through 3 V=R+M Incremetal after tax cash inflow in year 1 through 3 $282,876 3b Incremetal after tax cash inflow in year 4 U Incremetal after tax operating profit in year 4 $120,876 M Depreciation of initial capital $           150,000 W Cash inflow frm salvage $50,000 X=U+V+W Incremetal after tax cash inflow in year 4 $320,876 4 Payback Period: Year 0 1 2 3 4 Cash Flow ($650,000) $282,876 $282,876 $282,876 $320,876 Cumulative cash flow ($650,000) ($367,124) ($84,248) $198,628 $519,504 Payback period=Period in which cumultive cash flow =Zero Payback Period =(2+(84248/282876)=                      2.30 Years

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