Question 1
Senior Management at Pennants Distributors Limited is currently considering whether to invest in one of two machines: Vinnie and Cam. Both machines have a useful life of four years and are to be depreciated using the straight line basis. The cost, insurance and freight (CIF) of the Vinnie is Jamaican equivalent $20,000,000. The custom duty on the asset is J$5,000,000. The asset is to be depreciated to a residual value of $1,000,000. The Vinnie is to be bought in Miami, Florida. Meanwhile, the CIF of the Cam is Jamaican equivalent $24,000,000 and can be depreciated to a residual value of $2,000,000. The Cam is sold by a supplier in New York. The custom duties on the asset is J$6,000,000. The useful lives of the machines are the same as the project. However, the machines are mutually exclusive. The assets expect to increase efficiency by reducing annual operating costs. The annually savings from each machine were analyzed by the production manager and provided in a report to senior management below:
Year Vinnie Cam
1 $10,000,000 $16,000,000
2 $16,500,000 $16,000,000
3 $18,000,000 $16,000,000
4 $17,000,000 $12,000,000
The entity's projects are discounted using the weighted average cost of capital. The company's marginal tax rate is 40% and depreciation is an allowable deduction for income tax purposes. It is assumed that all cash inflows occur at the end of each year.
Projects are to be financed with 50% debt. The cost of debt is 12%. On the other hand, the cost of equity is determined using the capital asset pricing model. The risk free rate is half the cost of debt and the average return on the market is 16%. The stock's beta is 1.50.
Required:
a. Compute and explain briefly, the term cost of capital
b. Compute the following for each of the machines above:
i. Net present value
ii. Accounting rate of return using initial investment
iii. Internal rate of return
c. Advise senior management as to which machine is more feasible
Question 2
Montego Bay Ice produces three products, Light, Medium and Hard, all made from the same material. Until now, it has used traditional absorption costing to allocate overheads to its products. The company is now considering an activity based costing system in the hope that it
will improve profitability. Information for the three products for the last year is as follows:
Light Medium Hard
Production sales volume 15,000 12,000 18,000
Sales price per unit $7.50 $12 $13
Raw material usage (kg) per unit 2 3 4
Direct labour hours per unit 0.1 0.15 0.2
Machine hours per unit 0.5 0.7 0.9
Number of production runs per
annum 16 12 8
Number of purchase orders per
annum 24 28 42
Number of deliveries per annum 48 30 62
The price for raw materials remained constant throughout the year at $2 per kg. Similarly, the direct labour cost for the whole workforce was $14·80 per hour. The annual overhead costs were as follows:
Machine set-up costs
26,550.00
Machine running costs
66,400.00
Procurement costs
48,000.00
Delivery costs
54,320.00
Required:
a. Calculate the full cost per unit for all three products under the traditional method
b. Calculate the full cost per units for all three products under the ABC method
c. Identify and briefly explain three differences between the ABC and the traditional costing system