Should the company purchase a new kiln?RPW is considering purchasing a new kiln. It currently operates two kilns, each of which can process $10,000 worth of pottery per firing. The company received a quote of $500,000 for the materials to build a new kiln and the space to house it. Costs to erect the kiln, build the necessary additional space, and pre- pare it for production are projected at an additional $250,000. A new kiln will take one year to prepare for production.
RPW will have to finance the kiln with debt. The company's current interest rate is 10% (2% over prime). RPW's bank is reluctant to make such a large loan given RPW's current financial position. However, the bank believes it may be able to put together a group of area banks to finance the kiln with a 13% fixed rate loan requiring annual payments over five years. RPW estimates its required rate of return at 15% for this project.
The expected life of a kiln is seven years after which a major overhaul will be necessary. The kiln and additional space will be essentially worthless without the major overhaul. Assuming the kiln is fired twice a week, 50 weeks a year, with an average firing producing $10,000 worth of product (in sales dollars), the kiln would increase sales capacity $1,000,000. The company expects it could sell half of this increase in the first year with additional increases of $100,000 per year afterward. RPW estimates the cost to produce goods with a new kiln excluding depreciation at 45% of sales. Current marketing related costs average 20% of sales. RPW expects marketing expense to remain 20% on the additional sales because variable sell- ing expenses will increase, but fixed marketing expense will be spread over more sales. Administrative and general expenses should be unaffected by adding a new kiln.