Saskatoon Machinery Inc. manufactures drill bits. One of the production processes for a drill bit is called tipping, where carbide tips are inserted into the bit to make it stronger and more durable. This tipping process usually requires four or five operators depending on the weekly work load. The same operators were assigned to the stamping operation, in which the size of the drill bit and the company’s logo are imprinted into the bit. Saskatoon is considering acquiring three automatic tipping machines to replace the manual tipping and stamping operations. If the tipping process is automated, Saskatoon engineers will have to redesign the shapes of the carbide tips to be used in the machine. The new design requires less carbide, resulting in material savings. The following financial data has been compiled.
• Project life: 6 years.
• Expected annual savings: reduced labor, $56,000; reduced material, $75,000; other benefits (reduced carpal tunnel syndrome and related problems). $28,000; reduced overhead, $15,000.
• Expected annual O&M costs: $22,000.
• Tipping machines and site preparation: equipment (three machines) costs including delivery, $180,000; site preparation, $20,000.
• Salvage value: $30,000 (three machines) at the end of 6 years.
• Depreciation method: class 43 with d = 30%.
• Investment in working capital: $25,000 at the beginning of the project; that same amount will be fully recovered at the end of project.
• Other accounting data: Marginal tax rate of $39%, MARR of 18%. To raise $200,000, Saskatoon is considering the following financing options:
• Option 1: Finance the tipping machines using their retained earnings.
• Option 2: Secure a 12% term loan over 6 years (six equal annual installments).
(a) Determine the net after-tax cash flows for each financing option.
(b) What is Saskatoon’s present equivalent of owning the equipment by borrowing?
(c) Recommend the better course of action for Saskatoon.