NewTech Ltd is setting up a new manufacturing business. At this stage, two alternative production systems are being evaluated – System 1 (S1) and System 2 (S2). Both systems have a three-year life and no salvage value. Depreciation is straight line to a zero salvage value. The required return for both systems is 12%, and the corporate tax rate is 30%. Irrespective of which system is chosen, sales are projected to be 100 units per year, and the selling price per unit will be $35,000.
The major difference between the two systems is the cost structure, as S1 is relatively more labour intensive while S2 is more capital intensive. S1 costs $726,000 (at time zero), variable cost per unit is $26,000 and annual fixed costs (before depreciation) are $200,000. S2 costs $945,000, variable cost per unit is $22,000 and annual fixed costs (before depreciation) are $500,000.
A. Calculate the annual depreciation expense and operating break-even point for each production system. Note: You should treat depreciation expense as an annual fixed cost.
B. Calculate the degree of operating leverage for each production system.
C. Calculate the operating cash flows and NPV for each production system.
D. Use your findings from parts A to C above to compare and briefly discuss the benefits and risks of the two alternatives.