Smith Electronics manufactures portable CD players. Lillian
Perez, the VP of operations at Smith Electronics, is considering a major
capital investment decision. It would cost $2,500,000 to put new, highly
automated machines in the factory. The equipment would last about 15 years and
would have no salvage value at the end of that period. The equipment will
replace 10 workers, saving Smith $300,000 per year in direct labor. Operation
and maintenance costs on the machines are expected to cost $100,000 per year.
The automated equipment is expected to improve quality. Smith’s main
competitors are installing similar equipment. If Smith installs the equipment,
its revenues are expected to remain steady. If Smith chooses not to install new
equipment, its contribution margins expected to fall by $200,000 per year as a
result of lower quality compared to its competitors. Smith’s discount rate is
10% and its tax rate is 30%.
A. How much
is Smith expected to save each year if it installs the equipment (including tax
effects)?
B. How much
will Smith lose each year if it does not install the equipment (including tax
effects)?
C. Explain
how you would analyze this problem in order to determine if Smith should
purchase the new machines.
D. Should
Smith purchase the new machine?
E. Assume
that programming and maintenance costs turn out to be much higher than
Lillian’s estimates. However, despite the fact that the automation equipment
increased costs, Lillian still wants to continue with the project Explain why
Lillian might not want to scrap the equipment.
