P3 40 points A marketing product company ie the kind that ma

P3 (40 points): A marketing product company (i.e, the kind that makes small free-bees with your company\'s name on it to give away at trade shows and on college campuses) can either buy customized drink coasters at 5 cents each or install $500,000 worth of production equipment and manufacture the coasters at their plant. The manufacturing engineer estimates the material, labor, and other costs would be 3 cents per coaster. (a) If 12 million customized coasters per year are needed and the equipment is installed, what is the payback period? (b) The production equipment would be depreciated by sum-of-the-year-digits depreciation using a 5-year useful life and no salvage value. Assuming a combined 40% income tax rate, what is the after-tax payback period, and what is the after-tax rate of return:

Solution

Req a: Annual savings (cash inflows) Total units 12,000,000 Savings in Buying cost 0.02 (@ 0.05 -0.03) Annual cash inflows 240000 Initial investment 500000 Pay back period: 2.08 years (Initial investment/ Annual cash inflows Req b: Initial cost 500,000 Less: Salvage 0 Depreciable amount 500000 Sum of year 15 (5+4+3+2+1) Depreciation: YEar1 (500,000/15*5) 166667 YEar2 (500000/15*4) 133333 YEar3 (500000/15*3) 100000 Year 4 (500000/15*2) 66667 Year 5 (500000/15*1) 33333 Annual income and Annual rate of return Year 1 Year2 YEar3 Year4 Year5 Annual savings 240000 240000 240000 240000 240000 Less: Dep 166667 133333 100000 66667 33333 Net income beofre tax 73333 106667 140000 173333 206667 Less: Tax @40% 29333 42667 56000 69333 82667 Net Income after tax 44000 64000 84000 104000 124000 Average Income: 84000 Average Investment 250000 Annual Rate of return: 84000 /250000*100 = 33.60% (Average inome/ Average investment)*100 Annual cash inflows and Payback period Year Cahs flows Cumulative cash flows 0 -500000 -500000 1 210667 -289333 2 197333 -92000 3 184000 92000 4 170667 262667 5 157333 420000 After tax payback period: 2 years + 92000/184000 = 2.5 years