A manufacturer of packaging for companies that produce breakfast cereals is considering alternatives regarding the proce

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A manufacturer of packaging for companies that produce breakfast
cereals is considering alternatives
regarding the process it uses to pre-process carton paper used to
make the packaging. Historically, the
company has been using equipment which cuts raw carton paper
received from its various suppliers. This
cut paper is further painted and assembled into a box shape by two
other pieces of equipment.
Recently, however, most of its customers began requesting that
certain design elements be pressed into
the packaging, giving the packaging more visual appeal. The
customers were willing to pay more for the
added service, making it particularly lucrative for the firm to
have incorporate this possibility into its
packaging offerings.
Managers believed that the existing equipment would be able to
handle the new process with certain
modifications. In addition to modifying the existing equipment, the
company two other alternatives. All
alternatives will be able to produce the desired result, will
result in the same quality of finished produce,
satisfying the company’s and its customer’s demands, but differ in
annual maintenance costs, initial price,
and longevity.
The first alternative is to keep existing equipment, but update it
to handle the new process. The old
equipment was bought three years ago, at the price of US$4M and is
being depreciated on the straightline
basis over 8-year useful life to its expected salvage value of
zero. Managers determined that the old
equipment’s current market value is $1.5M, which is below its book
value due to significant expenses
associated with moving it somewhere else. The necessary updates,
which need to be depreciated over 4
years, will allow to provide the modifications that customers were
seeking. The expected cost of the
necessary updates is $1100K. The old equipment requires $400,000 in
annual maintenance expense.
The second alternative is to replace the old equipment with new
one. The new equipment would cost
US$2M to buy and install, requires $700,000 in annual maintenance
expense, but has a useful life of 6
years. It is also depreciated using straight-line method but has a
salvage value of $200,000 at the end of
its life.
The third alternative is to outsource the cutting of the paper to
an external contractor. This will involve
selling the existing equipment. The management expected that
external contractors would charge $1.3M
per year to produce the required quantity of pre-cut carton paper,
at the required quality, using the new
process with pressed elements. The added benefit of the outsourcing
is that it will allow to reduce days
of sales in inventories by 3 days, or roughly $300K, due to buying
the paper later in the production process.
Calculate the Equivalent Annual Cost of each alternative. What
alternative would be the least costly for
the company and what alternative should the company choose? The
company’s weighted average cost
of capital is 10% and its marginal rate of income tax is 21%.
EAC of keeping old equipment:
______________________________________
EAC of buying new equipment:
______________________________________
EAC of outsourcing: ______________________________________
The firm should: ______________________________________
because ______________________________________
Weighted Average Cost of Capital
Suggested sources of the data:
1. SEC’s Edgar database – for financial statements and annual
report
2. Stock returns from CRSP database – to calculate the beta (an
Excel file with the data is
available on Canvas. Column B is the date of the end of the
observation month, J is monthly
returns on Boeing’s stock, L is CRSP value-weighted index, N is
S&P 500 index returns).
3. FINRA’s TRACE database – for public bond yields and prices
4. U.S. Treasury’s web-site – for T-bond rates
5. Yahoo’s finance web-site, NASDAQ.com, or NYSE.com – for the most
current stock price