Ralph’s Enterprise (RE) manufactures hydraulic components for the aircraft industry. One element…

Ralph’s Enterprise (RE) manufactures hydraulic components for the aircraft industry. One element common to a variety of products is a specialized valve that RE manufactures. The estimated cost for this valve reveals the following:

Quality problems have surfaced and RE has decided the existing equipment must be replaced. An automated machine is available, at a cost of 2,500,000. It has a 5 year life, no salvage, and would be depreciated as 5 year equipment (MACRS percentages of 20%, 32%, 19.2%, 11.52%, 11.52% and 5.76%) for tax purposes. Straight line is used for book purposes. RE expects the direct material cost to remain the same, though direct labor will be cut in half if the new equipment is acquired. Also, variable overhead will remain at 1/3 of direct labor cost, although cash outlays presently in the “fixed” overhead (yes, the intercept of the LLA), totaling 450,000 per year, will not be incurred if the existing machine is retired. (It has zero salvage now, as well as a zero tax basis.) The marginal tax rate is a constant 40%. RE anticipates an annual demand of 50,000 valves. Just before signing the purchase contract for the new equipment, another firm in the industry offers to supply RE all the valves needed, at a guaranteed price of 30 per valve over the next 5 years. The after tax discount rate is 9%.

(a) Which option is best, make the valve with the new equipment or buy the valve from the outside supplier? What qualitative concerns do you see here?

(b) What will happen to the first year’s accounting income under each of the alternatives in (a)?

(c) What annual demand for the valve leads to indifference between the two alternatives?

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