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					NPV of JIT, income taxes (CMA, adapted).Cost accounting 12th edition page 754 chapter 21-31

The Shnider Group produces widgets for resale. The management is considering installing a JIT
system to better service its customers. The following facts are to be considered in the decision
process.

      Costs of the new system = $1,500,000
      Life of the system = 5 years
      Salvage amount or residual for tax purposes = $0
      Depreciation method = straight line = $300,000/year
      Equipment estimated sale price at end of the 5 years is = $100,000
      Service improvements will relate to an increase in revenues of $1,000,000 during the first
       year and this increase in revenue will grow at a rate of 5% per year for each year
       thereafter.
    The Shnider Group’s contribution margin is 60%
    An increase in smaller orders will cause:
           o An increase in inventory handling cost of $150,000
           o A reduction in the current annual cost of renting warehouse space of $80,000
    Working capital needs will decrease in year 0 by $200,000; increase in year 5 to
       $200,000
    Income tax rate is 30%
    Required rate of return is 12%
Should The Shnider Group purchase the new JIT system?
____________________________________________________________________________

 Initial investment (Year 0):                                     $1500000

    Working-capital investment:
      Reduced working capital of                 $200000 at end of Year 0.
      Increased working capital of               $200000 at end of Year 5.

    Depreciation on initial investment: $1500000  5 years = $300000 per year

    Income tax cash savings from annual depreciation deductions: $300000 × 0.30 = $90000

    After-tax cash flow from disposal of JIT system at end of Year 5: $100000 × (1– 0.30) = $70000

    Annual after-tax cash flow from operations:




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                                                                                                1
                                            Year 1            Year 2        Year 3        Year 4        Year 5
Incremental revenues
  (5% annual growth)                     $1,000,000         $1,050,000     $1,102,500    $1,157,625    $1,215,506
Incremental contribution margin
  (60%  incremental revenues)           $ 600,000           $ 630,000     $ 661,500     $ 694,575     $ 729,304
Rent savings                                80,000              80,000        80,000        80,000        80,000
Deduct increase in materials
  handling costs                            (150,000)          (150,000)     (150,000)     (150,000)     (150,000)
Annual pre-tax incremental
  cash inflow from operations                530,000            560,000      591,500       624,575       659,304
Deduct income tax payments
  (30%)                                      159,000            168,000      177,450       187,372       197,791
Annual after-tax incremental
  cash inflow from operations            $ 371,000          $ 392,000      $ 414,050     $ 437,203     $ 461,513


     The Shnider Group will have a NPV of $429,010 with the new JIT system. Based on financial
     quantitative factors, this is an attractive investment. Qualitative factors could make the JIT
     system even more attractive. For example, if a competitor adopts JIT but The Shnider Group
     does not, The Shnider Group could be at a sizable competitive disadvantage. Not adopting JIT
     does not mean the status quo will remain. The Shnider Group’s workers can also gain additional
     shop-floor expertise when using the JIT system that can be beneficially employed on other
     projects.




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                                                                                                            2
         SOLUTION :
                                      Present
                                        Value                              Sketch of Relevant After-Tax Cash Flows
                        Total         Discount
                       Present        Factors
                        Value          at 12%                Year 0         Year 1     Year 2    Year 3       Year 4      Year 5

1a. Net initial
investment            $(1500000)          1.000           $(1500000)
1b. Working
capital decrease           200,000          1.000                          $200000
2a. Annual after-
tax cash flow
from operations
Year 1                     331,303          0.893                          $371000
Year 2                     312,424          0.797                                     $392000
Year 3                     294,804          0.712                                                $414,050
Year 4                     278,061          0.636                                                             $437,203
Year 5                     261,678          0.567                                                                         $461,513
2b. Income tax cash
savings from annual
deprec. deductions
Year 1                      80,370          0.893                          $90000
Year 2                      71,730          0.797                                      $90000
Year 3                      64,080          0.712                                                 $90000
Year 4                      57,240          0.636                                                              $90000
Year 5                      51,030          0.567                                                                          $90000
3. After-tax cash flow from:
a. Terminal
disposal of
machine                     39,690          0.567                                                                          $70000
b. Increase in
working capital           (113,400)         0.567                                                                        $(200000)
Net
present value         $ 429,010




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                                                                                                                                      3
21-32 (40 min.) Replacement of a machine, income taxes, sensitivity.: Cost accounting
12th edition Chapter 21, 21-32 page 754

The Shnider Group produces widgets and purchased a new special cutting machine on January
1, 2003, which has been used for three years. It is January 1, 2006 and The Shnider Group is
considering whether it should purchase a new, more-efficient cutting machine. The company
has two options:
     Continue using the old machine
     Sell the old machine and purchase a new machine

                                                                  Old Machine      New Machine
Initial purchase cost of machines                                 $80,000         $120,000
Useful life from acquisition date (years)                         7               4
Terminal disposal value at the end of useful life on              $10,000         $20,000
Dec. 31, 2009, assumed for depreciation purposes
Expected annual cash operating costs
    Variable cost per widget                                      $.20            $.14
    Total fixed costs                                             $15,000         $14,000
Depreciation method for tax purposes                              Straight line   Straight line
Estimated disposal value of machines
   January 1, 2006                                                $40,000         $120,000
   December 31, 2009                                              $7,000          $20,000
Expected number of widgets made and sold each year                300,000         300,000

        Tax rate = 40%
        Any Gains/Loses on the sale of machines is treated as an ordinary tax item and will
         affect the taxes paid in the year in which it occurs
        After tax required rate of return = 16%
        All cash flows occur at year end except the initial investment amounts


ONE TIME AFTER TAX CASH EFFECT OF DISPOSING OF THE OLD MACHINE

. Original cost of old machine:                                                      $80,000
        Depreciation taken during the first 3 years
        {[($80,000 – $10,000) ÷ 7]  3}                                               30,000
        Book value                                                                    50,000
        Current disposal price:                                                       40,000
        Loss on disposal                                                             $10,000
        Tax rate                                                                      × 0.40
        Tax savings in cash from loss on current disposal of old machine             $ 4,000



ANNUAL RECURRING AFTER TAX CASH OPERATING SAVINGS FROM USING
    THE NEW MACHINE (VARIABLE & FIXED)


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                                                                                                  4
Difference in recurring after-tax variable cash-operating savings, with 40% tax rate:
          ($0.20 – $0.14)  (300,000)  (1– 0.40) = $10,800 (in favor of new machine)

Difference in after-tax fixed cost savings, with 40% tax rate:
           ($15,000 – $14,000)  (1 – 0.40) = $600 (in favor of new machine)


CASH TAX SAVINGS DUE TO DIFFERENCES IN ANNUAL DEPRECIATION OF
  THE OLD MACHINE AND THE NEW MACHINE
.                                                           Old Machine    New
  Machine
     Initial machine investment                               $80,000   $120,000
     Terminal disposal price at end of useful life             10,000     20,000
      Depreciable base                                        $70,000   $100,000
     Annual depreciation using
        straight-line (7-year life)                           $10,000
     Annual depreciation using straight-line (4-year life):              $ 25,000

                                                                                      Income Tax Cash
                                                                     Additional         Savings from
                                                                    Depreciation          Difference
             Depreciation               Depreciation              Deduction on New     in Depreciation
 Year       on Old Machine            on New Machine                  Machine         Deduction at 40%
  (1)             (2)                       (3)                     (4) = (3)  (2)       (4)  40%
 2006          $10,000                   $25,000                      $15,000             $6,000
 2007           10,000                    25,000                       15,000               6,000
 2008           10,000                    25,000                       15,000               6,000
 2009           10,000                    25,000                       15,000               6,000


DIFFERENCE IN AFTER TAX CASH FLOW FROM TERMINAL DISPOSAL OF
NEW MACHINE AND OLD MACHINE

    Old Machine                                             New Machine
       Original cost                                           $80,000                     $120,000
       Total depreciation                                       70,000                      100,000
       Book value of machines on Dec. 31, 2009                  10,000                       20,000
       Terminal disposal price of machines on Dec. 31, 2009      7,000                       20,000
       Loss on disposal of machines                              3,000                            0
       Add tax savings on loss (40% of $3,000; 40% of $0)        1,200                            0
       After-tax cash flow from terminal disposal of
        machines ($7,000 + $1,200; $20,000 – $0)               $ 8,200                     $ 20,000

Difference in after-tax cash flow from terminal disposal of machines: $20,000 – $8,200 =
$11,800.




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                                                                                                      5
   DECISION:

   The Shnider Group should retain the old equipment because the net present value of the
   incremental cash flows from the new machine is negative. The computations, using the results
   of requirement 1, are presented below. In this format the present value factors appear at the
   bottom. All cash flows, year by year, are then converted into present values.

                                                                         After-Tax Cash Flows
                                                    2005a             2006       2007       2008       2009
Initial machine investment                        $(120,000)
Current disposal price of old machine                40,000
Tax savings from loss on disposal of
  old machine                                           4,000
Recurring after-tax cash-operating savings
  Variable                                                           $10,800   $10,800    $10,800    $10,800
  Fixed                                                                  600       600        600        600
Income tax cash savings from difference in
  depreciation deductions                                              6,000     6,000      6,000      6,000
Additional after-tax cash flow from
  terminal disposal of new machine
  over old machine                                 ________ _______            _______    _______     11,800
Net after-tax cash flows                           $ (76,000) $17,400           $17,400    $17,400   $29,200
Present value discount factors (at 16%)                1.000    0.862             0.743      0.641     0.552
Present value                                      $ (76,000) $14,999           $12,928    $11,153   $16,118
Net present value                                  $ (20,802)
   a
       Actually January 1, 2006

              Let $X be the additional recurring after-tax cash operating savings required each year
              to make NPV = $0.
              The present value of an annuity of $1 per year for 4 years discounted at 16% =
              2.798
              To make NPV = 0, THE SHNIDER GROUP needs to generate cash savings with
              NPV of $20,802.
              That is    $X (2.798)     = $20,802
                                  X     = 20,802 ÷ 2.798 = $7,435

   THE SHNIDER GROUP must generate additional annual after-tax cash operating
   savings of $7,435.




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