LifeLine Corporation manufactures fire extinguishers. One part used in all types

Question

LifeLine Corporation manufactures fire extinguishers. One part used in all types of fire extinguishers is a unique pressure fitting that requires specialized machine tools that need to be replaced. LifeLine’s production manager has concluded that the only alternative to replacing these machine tools is to buy the pressure fitting from Milwaukee Pipe and Fitting Company. LifeLine could buy the fitting for $20 if a minimum order of 70,000 fittings is placed annually. LifeLine has used an average of 80,000 fittings over the past three years. The production manager believes this volume will remain constant for five more years.

*Depreciation accounts for two-thirds of the fixed overhead. The balance is for other fixed-overhead costs of the factory that require cash expenditures.

    If the specialized tools are purchased, they will cost $2,500,000 and will have a disposal value of $100,000 after their expected life of five years. Straight-line depreciation is used for book purposes, but MACRS is used for tax purposes. The specialized tools are considered 3-year property for MACRS purposes. The company has a 40 percent tax rate, and management requires a 12 percent after-tax return on investment.

    The sales representative for the manufacturer of the new tools stated, “The new tools will allow direct labor and variable overhead to be reduced by $1.60 per unit.” Data from another manufacturer using identical tools and experiencing similar operating conditions, except that annual production generally averages 110,000 units, confirm the direct-labor and variable-overhead savings. However, the manufacturer indicated that it experienced an increase in direct-material cost to $4.50 per unit due to the higher quality of material that had to be used with the new tools.

Use Appendix A and Exhibit 16-9. for your reference. (Use appropriate factor(s) from the tables provided.)

Complete the following net-present-value analysis schedules covering the life of the new specialized tools. (Negative amounts should be indicated by a minus sign. Round your "Per Unit" to 2 decimal places and other answers to the nearest dollar amount. Round your "Discount Factor" to 3 decimal places.)

I. Cost savings from manufacturing pressure fittings:

II. Discounted-cash-flow analysis

LifeLine Corporation manufactures fire extinguishers. One part used in all types of fire extinguishers is a unique pressure fitting that requires specialized machine tools that need to be replaced. LifeLine’s production manager has concluded that the only alternative to replacing these machine tools is to buy the pressure fitting from Milwaukee Pipe and Fitting Company. LifeLine could buy the fitting for $20 if a minimum order of 70,000 fittings is placed annually. LifeLine has used an average of 80,000 fittings over the past three years. The production manager believes this volume will remain constant for five more years.

Explanation / Answer

Answer 1-a. Particulars Unit Costs Units Amount Cost to purchase from Outside Supplier (a)               20.00    80,000.00    1,600,000.00 Incremental Costs of Manufacturing Fittings: Direct Material                 4.50    80,000.00        360,000.00 Direct Labor & Variable Overhead - $3.70 + $1.70 - $1.60                 3.80    80,000.00        304,000.00 Total Incremental Costs (b)        664,000.00 Cost Savings (a-b)        936,000.00 Tax - 40%        374,400.00 Net Cost savings from manufacturing fittings        561,600.00 Compuation of the Depreciation Tax Shield : Years Amount (a) Dep. Rate (b) Tax Savings © Tax Shield (a X b X c) Discount Factor - 12% Present Value 1    2,500,000.00 33.33% 40%                              333,300 0.893                      297,637 2    2,500,000.00 44.45% 40%                              444,500 0.797                      354,267 3    2,500,000.00 14.81% 40%                              148,100 0.712                      105,447 4    2,500,000.00 7.41% 40%                                74,100 0.636                        47,128 Total                      804,479 Particulars Cash Flows Discount Factor - 12% Present Value Annual Cost Savings        561,600.00 3.605             2,024,568 Depreciation Tax Shield                804,479 Salavage Value        100,000.00 0.567                   56,700 Tax on Gain of Sale - $100,000 X 40%        (40,000.00) 0.567                (22,680) Intial Investment          (2,500,000) Net Present Value                363,067 Answer 1-b. Yes. Management should replace the tools, since NPV is positive.

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