The case is set in a metalworking job shop in West Virginia , one of whose products is drill bits for oil exploration .
Posted: Wed Apr 27, 2022 10:42 am
The case is set in a metalworking job shop in West Virginia ,
one of whose products is drill bits for oil exploration . The time
is 1980 , in the midst of an oil drilling boom resulting from the
oil crises of 1973 and 1979 . Early in 1980 , Tom Mavis , President
of Mavis Machine Shop was considering a project to modernize his
plant facilities . The company operated out of a large converted
warehouse in Salem , West Virginia . It produced assorted machined
metal parts for the oil and gas drilling and production industry in
the surrounding area . One of Mavis’ major customers was Buckeye
Drilling , Inc ., which purchased specialized drill bits and
replacement parts for its operations . Mavis had negotiated an
annual contract with Buckeye to supply its drill bit requirements
and related spare parts in each of the past 8 years . In 1978 and
1979 the requirements had been about 8400 bits per year . All
Buckeye’s rigs were busy . Mavis knew there were 30 rigs operating
in the state in 1979 , up from 17 in 1972 . Wells drilled was up
even more , from 679 in 1972 to 1474 last year . The arrangement of
the machine shop included four large manual lathes currently
devoted to the Buckeye business . Each lathe was operated by a
skilled worker , and each bit required machining at all four lathes
. Mavis was considering replacing these manual lathes with an
automatic machine , capable of performing all four machining
operations necessary for a drill bit . This machine would produce
drill bits at the same rate as the four existing lathes , and would
only require one operator . Instead of skill in metalworking , the
job would now involve more skill in computerized automation . The
four existing manual lathes were 3-years-old and had cost a total
of $590 , 000 . Together they could produce 8400 drill bits on a
two-shift , 5-day / week basis . The useful life of these lathes ,
calculated on a two-shift / day , 5-day / week basis , was 1 This
case was written by Tom Graham at the Ohio State University under
the supervision of Professor John Shank . Analysing Technology
Investments 187 estimated to be 15 years . The salvage value at the
end of their useful life was estimated to be $5 , 000 each .
Depreciation of $114 , 000 had been accumulated on the four lathes
. Cash for the purchase of these lathes had been partially supplied
by a 10-year , unsecured , 10% bank loan , of which $180 , 000 was
still outstanding . The best estimate of the current selling price
of the four lathes in their present condition was $240 , 000 ,
after dismantling and removal costs . The loss from the sale would
be deductible for tax purposes , resulting in a tax savings of 46%
of the loss . The automatic machine being considered needed only
one skilled operator to feed in raw castings , observe its
functioning , and make necessary adjustments . It would have an
output of 8400 drill bits annually on a two-shift , 5-day basis .
Because it would be specially built by a machine tool manufacturer
, there was no catalog price . The cost was estimated to be $680 ,
000 , delivered and installed . The useful life would be 15 years .
Using a 12-year life (the remaining life of the current lathes) ,
the estimated salvage value would be 10% of cost . The automatic
lathe was first introduced in 1975 at a cost of $750 , 000 . It was
expected that as the manufacturing techniques became more generally
familiar , the price would continue to drop somewhat over the next
few years . This price decline was in stark contrast to the
inflation in oil services products and supplies which was 18% in
both 1978 and 1979 . A study prepared by the cost accountant to
help decide what action to take , showed the following information
. The direct labor rate for lathe operations was $10 per hour
including fringe benefits . Pay rates for operators would not
change as a result of machining changes . The new machine would use
less floor space , which would save $15 , 000 annually on the
allocated charges for square footage of space used , although the
layout of the plant was such that the freed space would be
difficult to utilize and no other use was planned . Miscellaneous
cash expenses for supplies , maintenance , and power would be $20 ,
000 less per year if the automatic machine were used . The purchase
price was subject to the 10% investment tax credit which did not
reduce the depreciable cost
Exhibit 1: Mavis Machine Shop Selected Financial information
Condensed Income statement 1979
Questions
1. Summarize the net cash flows for the proposed project
2. For the project calculate the internal rate of
return, the accounting rate o{ return, the par-tack period, the net
present value a:rd the profitability index'
3. what qualitative factors should be considered in
evaluating this project?
4. What decision would you recommend
one of whose products is drill bits for oil exploration . The time
is 1980 , in the midst of an oil drilling boom resulting from the
oil crises of 1973 and 1979 . Early in 1980 , Tom Mavis , President
of Mavis Machine Shop was considering a project to modernize his
plant facilities . The company operated out of a large converted
warehouse in Salem , West Virginia . It produced assorted machined
metal parts for the oil and gas drilling and production industry in
the surrounding area . One of Mavis’ major customers was Buckeye
Drilling , Inc ., which purchased specialized drill bits and
replacement parts for its operations . Mavis had negotiated an
annual contract with Buckeye to supply its drill bit requirements
and related spare parts in each of the past 8 years . In 1978 and
1979 the requirements had been about 8400 bits per year . All
Buckeye’s rigs were busy . Mavis knew there were 30 rigs operating
in the state in 1979 , up from 17 in 1972 . Wells drilled was up
even more , from 679 in 1972 to 1474 last year . The arrangement of
the machine shop included four large manual lathes currently
devoted to the Buckeye business . Each lathe was operated by a
skilled worker , and each bit required machining at all four lathes
. Mavis was considering replacing these manual lathes with an
automatic machine , capable of performing all four machining
operations necessary for a drill bit . This machine would produce
drill bits at the same rate as the four existing lathes , and would
only require one operator . Instead of skill in metalworking , the
job would now involve more skill in computerized automation . The
four existing manual lathes were 3-years-old and had cost a total
of $590 , 000 . Together they could produce 8400 drill bits on a
two-shift , 5-day / week basis . The useful life of these lathes ,
calculated on a two-shift / day , 5-day / week basis , was 1 This
case was written by Tom Graham at the Ohio State University under
the supervision of Professor John Shank . Analysing Technology
Investments 187 estimated to be 15 years . The salvage value at the
end of their useful life was estimated to be $5 , 000 each .
Depreciation of $114 , 000 had been accumulated on the four lathes
. Cash for the purchase of these lathes had been partially supplied
by a 10-year , unsecured , 10% bank loan , of which $180 , 000 was
still outstanding . The best estimate of the current selling price
of the four lathes in their present condition was $240 , 000 ,
after dismantling and removal costs . The loss from the sale would
be deductible for tax purposes , resulting in a tax savings of 46%
of the loss . The automatic machine being considered needed only
one skilled operator to feed in raw castings , observe its
functioning , and make necessary adjustments . It would have an
output of 8400 drill bits annually on a two-shift , 5-day basis .
Because it would be specially built by a machine tool manufacturer
, there was no catalog price . The cost was estimated to be $680 ,
000 , delivered and installed . The useful life would be 15 years .
Using a 12-year life (the remaining life of the current lathes) ,
the estimated salvage value would be 10% of cost . The automatic
lathe was first introduced in 1975 at a cost of $750 , 000 . It was
expected that as the manufacturing techniques became more generally
familiar , the price would continue to drop somewhat over the next
few years . This price decline was in stark contrast to the
inflation in oil services products and supplies which was 18% in
both 1978 and 1979 . A study prepared by the cost accountant to
help decide what action to take , showed the following information
. The direct labor rate for lathe operations was $10 per hour
including fringe benefits . Pay rates for operators would not
change as a result of machining changes . The new machine would use
less floor space , which would save $15 , 000 annually on the
allocated charges for square footage of space used , although the
layout of the plant was such that the freed space would be
difficult to utilize and no other use was planned . Miscellaneous
cash expenses for supplies , maintenance , and power would be $20 ,
000 less per year if the automatic machine were used . The purchase
price was subject to the 10% investment tax credit which did not
reduce the depreciable cost
Exhibit 1: Mavis Machine Shop Selected Financial information
Condensed Income statement 1979
Questions
1. Summarize the net cash flows for the proposed project
2. For the project calculate the internal rate of
return, the accounting rate o{ return, the par-tack period, the net
present value a:rd the profitability index'
3. what qualitative factors should be considered in
evaluating this project?
4. What decision would you recommend