Name:
Institution:
Lecturer:
Course:
Date:
SAC’s Choice to Purchase New Equipment
SAC is considering a proposed project of increasing the company’s revenue by uplifting its activity. Otherwise, it considers another proposal of purchasing equipment as a means of increasing specialty spark plugs production. This project is expected to raise production up to one hundred thousand plugs. The equipment in question has a life expectancy of five years and cost value of 3,000,000 dollars. The manufacturing cost of each plug is 8 dollars and is aimed to be sold at 20 dollars. Thus, the company will realize an 8 dollar profit upon the sale of each plug. In this case, the objective is to determine whether or not the equipment should be purchased (Harris, 2001).
The criteria I decided to implement are as follows: using the help of techniques in capital budgeting, NPV, IRR, and payback period. The application of these capital budgeting techniques in the course of this decision making, required formulation of cash flows statement. The cash flows of the company are ascertained as follows.
Revenue increment (100,000 x 12) 1,200,000
Less: depreciation -600,000
Pre tax profits 600,000
Less: taxes (34 percent) 204,000
Post tax profits 396,000
Add: depreciation 600,000
Post tax cash flows 996,000
Depreciation = 3,000,000/5 = 600,000
Depreciation is a non cash expense and thus is added back to profits after taxes (Harris, 2001).
(i) The payback period is referred to as the time length used when recovering investment cost (Smith, 2003). This period in this case will be calculated in the following means: Payback period is equal to project cost/ cash flows of the entire year. Decisions are based on the time deemed sufficient when recovering investment cost. In this case, the rule of the sooner the better will be applied. However, this approach suffers limitation. Cash flows are not discounted with regard to the current values (Smith, 2003). Nevertheless, calculation of the payback period for the company will be as follows.
| Year | Post tax cash flows |
| 0 | -3,000,000 |
| 1 | 996,000 |
| 2 | 996,000 |
| 3 | 996,000 |
| 4 | 996,000 |
| 5 | 996,000 |
Payback period therefore will be calculated as 3,000,000/ 996,000 = 3 years
(ii) Next on will be the calculation of the company’s net present worth (NPW) or net present value (NPV) (Smith, 2003). This refers to the present value total of a time cash flow series. It is a standard method that implements the use of time value in money terms when appraising long terms projects. It also measures shortfall or excess cash flows in present values. This is done in capital budgeting when financial charges have been met. In the case of SAC Company, I calculated its net present value as follows. I discounted the cash flows at the overall cost capital of SAC through the following means:
Weighted average cost capital = (cost of debt x weight of debt) + (cost of equity x weight of equity) = 6% x 0.4 (1 – 0.34) + 14% x 0.6
= 8.4% + 1.584%
= 9.984%
| Year | Profit Increment | Net profit | Depreciation | (34%)
Taxes |
Post tax Profits | Post tax cash flows |
| 0 | -3,000,000 | |||||
| 1 | 1,200,000 | 600,000 | 600,000 | 204000 | 396,000 | 996,000 |
| 2 | 1,200,000 | 600,000 | 600,000 | 204000 | 396,000 | 996,000 |
| 3 | 1,200,000 | 600,000 | 600,000 | 204000 | 396,000 | 996,000 |
| 4 | 1,200,000 | 600,000 | 600,000 | 204000 | 396,000 | 996,000 |
| 5 | 1,200,000 | 600,000 | 600,000 | 204000 | 396,000 | 996,000 |
| 3,777,167.40$ | ||||||
| NPV = | 777,167.40$ | |||||
| IRR = | 20% | |||||
IRR- Internal Return Rate, is the rate of discount implemented in capital budgeting. This brings the overall present value of a particular project’s cash flows as equal to zero (Tekavcic, 2003). Primarily, the rate of return of a project is, the more favorable it would be to accept the project. In this case, the internal return rate can be utilized when ranking prospective projects a company could be considering. I assumed all other factors were held constant considering other projects. Therefore, the project with the highest return rate would be considered most appropriate and prioritized most.
Decision
In the case of Sparklin Automotive Company, the net present value exhibits a positive reaction. This implies that the present value of the company’s cash flows is greater than current investment being enforced (Tekavcic, 2003). In addition, the internal rate of return is greater than the total cost of capital. Therefore, I can conclude that this proposed project should be accepted, and the new equipment can be purchased to increase the revenue. With the foregoing decision, the following is my explanation for the sales volume increase on unit fixed costs, total fixed costs, unit variable cost, and total variable cost.
Fixed costs will remain constant in the short period even when there is a variation in the sales period (Harris, 2001). A good example of this scenario includes rent and sales. If changes in capacity occur to provide goods and service, a change in fixed cost will then occur, which is also referred to capacity fixed cost. Another effect of an increase in sales volume on the total fixed cost will be an increase in sales volume, as cost per unit exhibits a decrease (Harris, 2001). Variable costs per single unit will also remain unmoved. This is because the total variable costs have a proportionate variance with sales volume.
Notwithstanding, I will also discuss the effect of increased sales volume on increase in sales price, and the decrease on the overall operating income. This effect will lead to an increase in the volume of sales as well as an increase of the net income. An increase in selling price would also result to an increase in the overall income used for operational activities (Smith, 2003). Finally, increase in sales volume would also have an effect on profit maximization and cost reduction. Thus I can conclude that net income would exhibit an increase if there was a decrease in operational costs.
Recommendation
From my findings, it is in my opinion that Sparklin Automotive Company should employ the proposed project of purchasing the new equipment to increase its spark plug production. This will ensure that overall profit of the company will be increased. Basing my argument on techniques of capital budgeting, I am able to draw the following conclusions. My calculations established the payback period as three years, and the life time of the project is five years. The present net value is positive, and the internal rate of return is greater than the net capital cost. On the other hand basing my argument on the behavior of cost, I managed to come up with the following conclusions. An increase in the volume of sales as well as a decrease in costs will lead to an income increase for any company and that this should be held constant (Smith, 2003). In conclusion, the Sparklin Automotive Company should employ the purchasing of new equipment to increase the production of spark plugs. This would therefore lead to an increase in the company’s net income.
While variable costs have behavior patterns prompting chief concern from the management in Sparklin Automotive Company, they should also address step variable costs in the possible unique savings capable of being presented. Sparklin Automotive Company and any other automotive parts manufacturer will be in need of a long term strategy capable of saving money. This would then attract numerous external companies willing to contract or outsource on the strategy in question. The raw materials required to by the company to manufacture spark plugs can be acquired at low prices when purchased in large masses. Therefore, it should be the mind set of Sparklin Company to shift its focus in particular times of the year when raw materials are cheap (Tekavcic, 2003), and also to meet the fluctuating supply of the spark plugs.
While these kinds of recommendations may appear monumental, the management may seek to initiate them one at a time in a streamlined manner. This strategy will therefore allow the assessment and analysis Sparklin Automotive Company has been seeking to optimize both its output and performance. In my opinion, these kinds of strategies will inspire the company to greater heights, and achieve its goal of maximizing revenues while lowering its expenses. Fortunately, many ways are available to achieve this feat, and Sparklin Company has identified one of them.
Reference
Harris, E. (2001). Job costing, contract costing & cost bookkeeping. London: Financial Training.
Lewis, R. J. (2005). Activity-based costing for marketing and manufacturing. Westport, Conn: Quorum Books.
Smith, W. A. (2003). Outline of costing: A brief survey of job costing for factories. London: Moore’ Modern Methods.
Tekavcic, M., & Peljhan, D. (January 01, 2003). Activity-based cost management: The European Journal of Management and Public Policy, 2, 1, 49-64
Use the order calculator below and get started! Contact our live support team for any assistance or inquiry.
[order_calculator]