Maddy St. Clair and Crozier Products
Maddy St. Clair was flabbergasted! When she had made her presentation last month to her company's strategic team about introducing a new line of injection molded plastic products, she was confident that they would green light the project, but she never expected them to put her in charge of it. She would be the youngest project manager in the history of Crozier Products, a molded plastic products manufacturer located in Australia and a wholly-owned subsidiary of a large, multinational company.
The genesis of Maddy's proposal was something she had heard from a friend of a friend. A small company in South Korea had recently perfected a new type of injection molding equipment. After doing some research on this new equipment, Maddy had realized that it would allow Crozier Products to develop a new line of products that had not been technologically feasible to manufacture until now. Exhibit 1 shows selected portions of the analysis for the new product line that Maddy presented to Crozier Products' strategic team.
The enormity of her task slowly began to dawn on Maddy. The success or failure of the new product line-from manufacturing through sales-rested on her shoulders. Troubling thoughts starting racing through her mind: What if my financial projections had been wrong? What if the new injection molding equipment is not the breakthrough I think it is? What if my team doesn't take me seriously because of my age? Maddy took a deep breath, regained her composure, and starting thinking about the various issues she would have to address to get the new product line up and running.
Although it was necessary to estimate overall demand for the production line, Maddy was thankful that production would be based solely on customer orders so that she would not have to estimate demand for individual types of products. She also realized that this meant she would not need to manage finished goods inventory; inventory would be largely limited to raw materials. Thoughts of inventory started Maddy thinking about the "Financial Management for Non-Financial Managers" executive education course she had taken last year and what might be relevant from that course. She knew that Crozier Products used first-in, first-out (FIFO) for all its inventory, so that was one decision she would not need to make. Some of the issues discussed in class about property, plant and equipment (PP&E) started to come back to Maddy; for example, she remembered that she would not need to choose a depreciation method for tax reporting because the tax code dictated the method companies had to use for tax reporting. However, she still was fuzzy about depreciation for financial reporting. She couldn't remember whether depreciation was that important given that it is not an actual cash flow, or the extent to which her choice of useful lives and depreciation methods would affect her product line's profitability. Many other thoughts raced through her mind as she started planning for her first meeting with her team next week. One thing she mentally noted to review was the parent company's PP&E note to its financial statements (see Exhibit 2).
"Where did the last three months go?" Maddy thought to herself as she walked through the new production line on 31 December 2009, stopping in front of the centerpiece of the production line: the new injection-molding unit. This unit comprised 70% of all the PP&E for the production line and had cost $2.0 million, plus $193,800 for import duties and $42,400 for delivery and assembly. It then took ten members of Crozier Products' maintenance staff one week to install the injection-molding unit and another week to test it. The weekly wage for a maintenance person is $1,000, and fringe benefits average an additional 20% of wages while payroll taxes are an additional 10% of wages. The maintenance manager had estimated that when it was time to get rid of this unit, it would take six members of his staff a full week to dismantle it.
Maddy could not believe the production line was going live in four days when everybody returned to work after the long New Years' weekend holiday. Maddy was quietly confident; the sales team was running a little behind on getting customer orders, but there were more than enough orders to keep the production line busy for January. She also wondered how much of her product line's 2010 bonus pool would go to her; she and her partner had been hoping to renovate their house and the bonus could come in handy.
Part I: Base Questions:
1. Maddy consulted with Crozier Product's accounting department about what dollar amount should be included in the PP&E account as of 1 January 2010 for the new injection-molding unit. Below is the calculation by the accounting department.
Amount that should be capitalized for new injection-molding unit as of 1 January 2010
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Purchase price
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$2,000,000
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Import duties
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193,800
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Delivery and assembly
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42,400
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Installation 1
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13,000
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Testing 2
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13,000
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Estimated dismantling cost 3
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7,800
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Total Capitalized Amount
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$2,270,000
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1 10 Employees x 1 Week of wages x {$1,000 Wages per week per employee x [1 + (20% additional for fringe benefits + 10% additional for payroll taxes)]}
2 10 Employees x 1 Week of wages x {$1,000 Wages per week per employee x [1 + (20% additional for fringe benefits + 10% additional for payroll taxes)]}
3 6 Employees x 1 Week of wages x {$1,000 Wages per week per employee x [1 + (20% additional for fringe benefits + 10% additional for payroll taxes)]} Note that discounting has been ignored (1) because wages are stated in today's dollars and (2) for simplicity.
Maddy was confused by the calculation as she did not understand why so many items other than the purchase price for the equipment are included in the book value of the equipment. Provide a clear and concise explanation to Maddy for the rationale for the calculation.
2. What factor(s) should Maddy consider in selecting the injection-molding unit's useful life for depreciation purposes?
3. Assume Maddy estimates that the company will use the injection-molding unit through 31 December 2019 and that its residual value is $120,000. Create a table similar to the one below and then complete it for the injection-molding unit.
4. What factor(s) should Maddy consider in selecting a depreciation method for the injection-molding unit?
Part II: Assume that Maddy eventually decided to base depreciation for the injection-molding unit on straight-line depreciation through 31 December 2019, with residual value of $120,000. Answer the following future scenario questions:
Future Scenario
Maddy was reviewing her product line's preliminary financial statements for the 11 months ended 30 November 2012. The results for 2010 and 2011 had slightly outperformed her initial forecasts, but the results for 2012 were significantly below budget. Maddy thought she had been conservative three years earlier when she put together her initial forecasts for the new product line. However, she had not anticipated the resurgence of financial problems in Europe, and their ripple effect on the American economy. She also had not anticipated that the Australian dollar would stay above parity with the US dollar for so long, with the resulting negative effects on exports to international customers.
One consequence of all these factors was that there was not much of a used market for the injection-molding unit; Maddy figured that the unit was now worth only about $1.0 million (net of all disposal costs). Nonetheless, Maddy still believed that her initial estimates for the useful life and residual value of the injection-molding equipment were reasonable and appropriate.
Maddy turned her attention to the revised budget forecasts of annual cash flows before taxes for the product line for 2013 through 2019 (see Exhibit 3). The numbers were not pretty, but Maddy thought they were reasonable given the current economic climate.
Questions for Future Scenario
1. What dollar amount should Crozier Products allocate to 2012 as depreciation on the injection-molding equipment?
2. What dollar amount should Crozier Products include on its 31 December 2012 balance sheet in Accumulated Depreciation for the injection-molding equipment?
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Value-in-Use of Injection-Molding Equipment on 31 December 2012
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This analysis is based on a 7-year project life and the company's 10% weighted-average cost of capital.
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Cash Flow
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Present Value
Factor
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Present value
of Cash Flow
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Annual cash flows before taxes (from Exhibit 3)
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$308,000
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4.8684
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$1,499,473
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Percentage of PP&E that is injection-molding equip.
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70%
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Present value of expected operational cash flows
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$1,049,631
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Present value of residual value
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120,000
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0.5132
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61,579
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Value in use of injection-molding equipment
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$1,111,210
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3. Given your answer to the last question, what dollar amount should Crozier Products allocate to 2013 as depreciation on the injection-molding equipment?