Question

Birmingham Bolt, Inc., has been approached by one of its customers about producing 800,000 special-purpose parts for a new home product. The customer wants 100,000 parts per year for eight years. To provide these parts, Birmingham would need to acquire a $500,000 new production machine. The new machine would have no salvage value at the end of its eight-year life. The customer has offered to pay Birmingham $7.50 per unit for the parts. Birmingham’s managers have estimated that, in addition to the new machine, the company would incur the following costs to produce each part:
Direct labor $2.00
Direct material $2.50
Variable 2.00
Total $6.50

In addition, annual fixed out-of-pocket costs related to the production of these parts would be $20,000.

a. Compute the net present value of the machine investment, assuming that the company uses a discount rate of 9 percent to evaluate capital projects.
b. Based on the NPV computed in (a), is the machine a worthwhile investment? Explain.
c. In addition to the NPV, what other factors should Birmingham’s managers consider when making the investment decision?

Answer 1

Answer:

Birmingham Bolt, Inc.

a. The net present value of the machine investment = ($57,214.47).

b. Based on the computed NPV in (a), the machine is not a worthwhile investment.  Birmingham will lose $57,214.47 from the investment.

c. In addition to the NPV, the other factors that Birmingham’s managers  should consider when making the investment decision are:

1. the probability of reducing the variable costs per unit of production by achieving productivity efficiencies.

2. whether the price could be reviewed upward with the customer.

3. whether there will be increased demand for the product in the future.

Explanation:

a) Data and Calculations:

Special-purpose parts for a new home product = 800,000 parts

Annual requirement of the parts = 100,000

Period of contract = 8 years

Discount rate = 9%

Initial investment in production machine = $500,000

Price offer per part = $7.50

Annual sales revenue from parts = $750,000

Variable costs;

Direct labor      $2.00

Direct material $2.50

Variable           $2.00

Total                $6.50                     $650,000

Contribution margin                      $100,000

Annual fixed costs                          $20,000

Annual net cash inflow                  $80,000

PV of annual cash inflows = $442,785.53

NPV = ($57,214.47) ($442,785.53 - $500,000)

N (# of periods)  8

I/Y (Interest per year)  9

PMT (Periodic Payment)  80000

FV (Future Value)  0

Results

PV = $442,785.53

Sum of all periodic payments = $640,000.00

Total Interest = $197,214.47