Alternative Pricing – Capital Budgeting

Alternative Pricing – Capital Budgeting

As the newly hired investment analyst for the McClain & Moss (M&M) Brassiere Company, you have been asked to evaluate a new manufacturing process that will eliminate all metal parts of the M&M Bra.  Not only will this new design eliminate the metal parts but it will also increase sales from 4,000,000 bras per year to 5,200,000 bras per year.  The new design will also make it easier to get through airport metal detectors.

 

The current/existing manufacturing equipment/process has a current book value (adjusted basis) of  $8,000,000, it has been in place for four years and is being depreciated to zero using the straight-line method over an original seven-year life.  Each of the currently sold M&M Bras wholesales for $9.50 and each has a total incremental cost of production of $6.50.  It is expected that 4,000,000 bras will be sold each year for the next five years if the current product, manufacturing machinery and process are continued. The salvage value today of the existing equipment is $6,000,000.  Current net working capital (cash, inventories, and accounts receivables) is $2,400,000 and current accounts payable is $800,000.  Net working capital would be totally recovered if the firm went out of business.

 

The new machinery and manufacturing process, which eliminates the metal in the M&M Bra, will have an incremental, per unit, production cost of $5.50.  M&M can produce and sell 5,200,000 new bras each year for $11.50 each for the next 5 years.  The new machinery and process has a projected installation cost of $72,000,000.  In addition to the installation cost, working capital (cash, inventories, and accounts receivables) will increase by a total of $1,000,000 (total working capital of $3,400,000) and accounts payable will increase by a total of $400,000 (total accounts payable of $1,200,000) resulting in a net increase in working capital of $600,000.

 

The salvage value of the old machinery in 5 years is expected to be $2,000,000; whereas; it is expected that the salvage value of the new machinery in 5 years will be $8,000,000.

 

The firm is in the 40 percent tax bracket for the next 5 years, and that the after-tax, weighted average cost of capital is 10 percent.  Unlike the old machinery, the new machinery will be depreciated to zero using MACRS 7-year class life.

 

The firm currently has four alternatives.  1. Continue the current operation-producing and selling the old bra.  2. Acquire the new machinery and manufacturing process and produce and sell the new bra, 3. Instead of producing the old bra, buy the old bra from a reliable supplier for $8.00 each and sell it under the M&M Bra name or 4. Buy the new bra from a reliable supplier for $10.20 each and sell it under the M&M Bra name.  Which alternative should M&M select assuming these are 4 mutually exclusive alternatives?

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