Assignment:
The Special Products division of Plastics Unlimited makes specially designed night goggles. Its main production machine broke down on Jan. 1, 2008 and was no longer usable. The manager of the Special Products Division (SPD) requested $320.000 to acquire a new machine. Corporate management responded by requesting an analysis of the acquisition as well as an analysis of closing down SPD. SPD’s 2007 income statement follows:
Special Products Division
Income Statement for 2007
Sales (60,000 units) $1,200,000
Deduct costs:
Variable production costs $770,000
Fixed production cost (that do not
Vary with units produced and sold)
Machine depreciation $30,000
Patent amortization 25,000
Machine maintenance 20,000
Building space 20,000
Manger's salary 55,000
Other fixed costs 15,000
Total fixed production costs 165,000
Variable marketing costs 130,000
Total costs 1,065,000
Operating Income $135,000
The externally reported book values of the division assets as of December 32, 2007 are:
Cash $190,000
Machine 60,000
Patent 125,000
Total $375,000
The contribution margin is expected to remain the same over the next five years if SPD continues to produce and sell goggles.
To make the goggles the company had to acquire a patent three years ago for $200,000. The patent is being amortized (that is, written off on the income statement) evenly over its lifetime. If the company were to shut down SPD, the patent could be sold for $235,000 to an external buyer.
The existing machine was purchased for $150,000 three years ago. It is depreciated on a straight line basis over five years. Zero salvage value is assumed for depreciation purpose. The current cash disposal value of the broken machine is $4,000.
The new machine has a useful life of 5 years and an expected salvage value of zero for depreciation purpose. Its cash disposal value in 5 years is expected to be $50,000. It would be depreciated under the straight line method. Maintenance of the new machine would require $25,000 per year.
SPD uses 1,000 square feet of building space and is charged $20 per square foot by corporate management. If SPD is eliminated, the space can be rented externally for $30 per square foot.
If SPD were closed, its managers would become an assistant manager in another, larger department. He would receive a salary of $60,000. If the company fills this position with An outsider it will have to pay $65,000 in salary.
Other fixed costs consist of miscellaneous items such as insurance and indirect labor that would remain at the same levels if SPD continues to produce the goggles and would not be incurred if SPD is closed down.
The firm uses a required rate of return of 12% and tax rate is 30%.
Required to do:
1. On the basis of the net present value criterion, should Plastics Unlimited purchase the new machine or close down SPD? Prepare a financial analysis. List the assumptions underlying your baseline analysis.
2. Prepare a sensitivity analysis to examine how changes in the assumptions will affect your final computations. For example, you may want to consider (1) changes in tax rates; (2) changes in required rate of return’ (3) changes in your prediction on the quantity of goggles; and (4) any other change you can think of.
3. What non-financial and qualitative factors should Plastics Unlimited consider before coming to a decision?