Question

Questions 1 & 2 ask for cash flows only, no present values. They are a critical part of the problem.

Questions 3 & 4 require that you use the correct cash flows from 1 and 2 to determine the net present values of the two alternatives.

The Brisbane Manufacturing Company produces a single model of a CD player. Each player is sold for $204 with a resulting contribution margin of $72.

Brisbane's management is considering a change in its quality control system. Currently, Brisbane spends $41,500 a year to inspect the CD players. An average of 2,100 units turn out to be defective - 1,680 of them are detected in the inspection process and are repaired for $80. If a defective CD player is not identified in the inspection process, the customer who receives it is given a full refund of the purchase price.

The proposed quality control system involves the purchase of an x-ray machine for $180,000. The machine would last for four years and would have salvage value at that time of $21,000. Brisbane would also spend $440,000 immediately to train workers to better detect and repair defective units. Annual inspection costs would increase by $20,000. This new control system would reduce the number of defective units to 380 per year. 320 of these defective units would be detected and repaired at a cost of $48 per unit. Customers who still received defective players would be given a refund equal to 120% of the purchase price.

1. What is the Year 3 cash flow if Brisbane keeps using its current system?

2. What is the Year 3 cash flow if Brisbane replaces its current system?

3. Assuming a discount rate of 8%, what is the net present value if Brisbane keeps using its current system?

4. Assuming a discount rate of 8%, what is the net present value if Brisbane replaces its current system?

Answer 1

Assume that Brisbane Manufacturing Company sells 10,000 qty/year
Qty sold	10,000	10,000	10,000
Sales price per piece (given)	204	204	204
Contribution per piece (given)	72	72	72
	year 1	year 2	year 3
Cash Beginning of the year	-	4,58,420	9,16,840
Cash Receipts from Customers	20,40,000	20,40,000	20,40,000
Cash paid for
Inventory Purchases	13,20,000	13,20,000	13,20,000
General & Administrative Expenses	2,61,580	2,61,580	2,61,580	Annual inspection cost=41500
Wages				1680 defective units repair cost@80
Interest				payment for defective stock 420@204
Income Taxes
Net Cash Flow from operations	4,58,420	4,58,420	4,58,420
Inventing Activities
Cash Receipts from
Sale of Equipment & Property
Principal Loan Collection
Sale of Securities
Cash paid for
Purchase of Equipment & Property
Loan to other Entities
Purchase of Securities
Net Cash Flow from Investing Activities	-	-	-
Financing Activities
Cash Receipts from
Issuance of Stock
Borrowings
Cash paid for
Repurchase of Stock
Repayment of Loans
Dividends
Net Cash Flow from Financing Activities	-	-	-
Net Increase in Cash	4,58,420	4,58,420	4,58,420
Cash at the End of year	4,58,420	9,16,840	13,75,260
2.If Brisbane replaces current system
Assume that Brisbane Manufacturing Company sells 10,000 qty/year
Qty sold	10,000	10,000	10,000
Sales price per piece (given)	204	204	204
Contribution per piece (given)	72	72	72
	year 1	year 2	year 3
Cash Beginning of the year	-	4,952	6,29,904
Cash Receipts from Customers	20,40,000	20,40,000	20,40,000
Cash paid for
Inventory Purchases	13,20,000	13,20,000	13,20,000
General & Administrative Expenses	5,35,048	95,048	95,048	including Training cost - 440,000
Wages				Annual inspection cost=41500+20000
Interest				320 defective units repair cost@48
Income Taxes				payment for defective stock 60@204*120%
Net Cash Flow from operations	1,84,952	6,24,952	6,24,952
Inventing Activities
Cash Receipts from
Sale of Equipment & Property
Principal Loan Collection
Sale of Securities
Cash paid for
Purchase of Equipment & Property	1,80,000	-	-	Purchase of X Ray Machine
Loan to other Entities
Purchase of Securities
Net Cash Flow from Investing Activities	-1,80,000	-	-
Financing Activities
Cash Receipts from
Issuance of Stock
Borrowings
Cash paid for
Repurchase of Stock
Repayment of Loans
Dividends
Net Cash Flow from Financing Activities	-	-	-
Net Increase in Cash	4,952	6,24,952	6,24,952
Cash at the End of year	4,952	6,29,904	12,54,856

3.NPV - if Brisbane keep using the current system = Today's value of expected cash flow - Salvage value

=

NPV=cash flow year 1/(1+.08)+ cash flow year 2/(1+.08)*(1+.08)+Cash flow year 3/(1+.08)*(1+.08)*(1+.08)-salvage value

4,24,463

4,58,420

4,94,094

$ 1,377,977

4.if Brisbane replaces its current system = Today's value of expected cash flow - Salvage value

NPV

4,585

6,24,952

6,74,948

= $1,304,485 - $21,000 = $1,283,485