Allen Manesfield, Jenny Winters, and John Jacobsen have been discussing a persistent and irritating production problem. The three are employed by Honley Medical, which specializes in the production of medical products and has three divisions: the IV Products Division, the Critical Care Monitoring Division, and the Specialty Products Division. Allen, Jenny, and John are associated with the IV Products Division Allen as the senior production engineer, Jenny as the marketing manager, and John as the divisional controller. The three constitute the division’s capital acquisitions committee, with Allen serving as the chair.
The IV Products Division produces intra- venous needles (IVs) of five different sizes. During one stage of the manufacturing process, the needle is inserted into a plastic hub and bonded using epoxy glue. According to Jenny, the epoxy glue was causing the division all kinds of problems. In many cases, the epoxy wasn’t bonding correctly. The rejects were high, and the division was receiving a large number of complaints from its customers. Corrective action was needed to avoid losing sales.
One possibility was to use induction weld- ing in lieu of epoxy bonding. In induction welding, the needles are inserted into the plastic hub, and an RF generator is used to heat the needles. The RF generator works on the same principle as a microwave oven. As the needles get hot, the plastic melts, and the needles are bonded. Switching to induction welding would require an investment in RF generators and the associated tooling. But induction welding promised to reduce the cost of direct materials, eliminating the need to buy and use epoxy. Savings of direct labor costs were also predicted because the welding process is much more automated. Adding to these savings were the avoidance of daily clean-up costs and the reduction in rejects.
Several questions in the committee arose concerning this capital acquisition decision: Would the investment increase the value of the firm? Would it earn at least the rate of return required by the company? How long would it take the firm to recover the investment given the predicted savings? After discussion and analysis, the committee concluded that the investment was justified based on the savings associated with the new system. Using the predicted savings, the committee presented headquarters with a formal net present value analysis showing that the welding system was economically superior to the epoxy system and an analysis confirming that the expected return was greater than the division’s cost of capital. Based on these analyses, headquarters approved the purchase of the new system.
Questions to Think About
1. What role, if any, should qualitative factors play in capital budgeting decisions?
2. How do we measure the financial benefits of long-term investments?
3. Why are cash flows important for assessing the financial merits of an investment?
4. What role do taxes and inflation play in assessing cash flows?
5. Should the cash flows of intangible factors be estimated?