Case Study: SCRUB DUDS LAUNDRY

After reading the article, please write short paragraphs for the question A-G below, please include the necessary calculations. Also, write a memo for question H.

A. Is this decision a new project or equipment replacement What types of cash flows are relevant for this type of decision Categorize and sum the relevant cash flows.

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C. Use your judgment to determine the estimated life of the project (number of years of cash flows to be included in the NPV analysis) and explain your choice.

D. Considering the risk of the project, determine a risk premium and explain your choice.

F. Identify which of the pieces of information used in the NPV calculation are uncertain. Explain why these uncertainties are important to John Forsythe’s decision.

G. Identify possible qualitative factors that Forsythe might consider in making his decision. Identify as many factors as you can.

H. Write a memo to John Forsythe explaining whether he should purchase the new pressing machine. Include the most important factors that Forsythe should consider in making his decision. Provide Forsythe with any other suggestions you might have to help him improve the profitability.

 

In January 2009, Scrub Duds Laundry installed a new shirt-pressing unit.The results obtained from operating this unit were so satisfactory that early in 2010 John Forsythe, president of the laundry, was considering the purchase of a second new shirt-pressing unit.

 

In the preceding several years, Scrub Dud’s sales had amounted to roughly $350,000 each year.  John thought that sales probably would not change much during 2010, but he hoped eventually to increase sales volume.  The business was subject to slight seasonal fluctuations, which necessitated employment of part-time labor during parts of the year.

 

The laundry had always operated profitably; although in recent years the shirt-laundering section had done no better than break even.  Since shirts made up an important part of the laundry’s business, Forsythe was extremely anxious to make this part of the operation profitable.  He had considered the possibility of raising shirt-laundering prices to the customer but had rejected this alternative because of intense competition.

 

 

In 2008, to determine where costs might be reduced, Forsythe made a careful analysis of the operations performed on shirts.  He concluded that high costs in the pressing department were his principal problem.  At that time the shirt-pressing department included three separate but similar pressing units, called Units A, B and C.  Each unit consisted of four presses.  In each of Units A and B, a cuff and collar press and a front press were operated by one operator, a back press and a sleeve press were operated by a second operator, and two other workers performed touch-up ironing and folded the finished shirts.  Each of these two pressing units had a capacity of 90 shirts an hour.  Unit C had four similar presses, but it was operated only when there were more shirts to be pressed than the other two units could handle.  Two people employed on a part-time basis operated Unit C and turned out 40 shirts an hour.

 

Both the full-time and part-time employees were paid $7.50 an hour, and social security taxes and fringe benefits increased this expense to $10.00 an hour.  The company did not have a piecework incentive plan, but the workers were free to leave the plant when they finished a day’s work.  Full-time operators were guaranteed and paid for a 40-hour week.  In practice, however, they averaged only 27.5 hours of actual work in a week; they had one hour off for lunch and two 15-minute rest periods daily.  The remaining five hours a week was accounted for by their practice of leaving early.  Part-time help was employed to operate a third unit rather than work the full-time operators over 27.5 hours per week.

 

In order to reduce shirt-pressing costs, Forsythe made a major change in the shirt-pressing department in January 2009.  At that time, he replaced Unit A with a new pressing unit, the Quick-Press Model 70.

 

Each of the old units cost $32,200 when purchased, and installation charges for all three units amounted to $1,030.  The old units were 18 years old, however, and were fully depreciated on the laundry’s books.  With periodic replacement of parts and routine maintenance, they probably could have been kept in operating condition indefinitely, but Forsythe thought that the new type of press made them obsolete.  The old presses had no resale value.

 

The new Quick-Press unit occupied only about half the space of one of the old units.  Building depreciation, light, and other space costs allocated to each press unit totaled approximately $4,600 a year.  Thus, the saving in space for the new unit was worth $2,300 a year.

 

On the Quick-Press unit, one worker operated both a collar and cuff press and also another machine that pressed the body of the shirt in one operation.  This worker was able to operate these two presses simultaneously because of automatic timers that made it unnecessary to watch one press while inserting or removing a shirt from another press.  A second person operated the sleeve press and performed all of the folding for the unit.  The touch-up, hand-ironing operation was eliminated completely.  The appearance of shirts turned out by the new Quick-Press unit was much improved over those turned out by the old units, even with touch-up ironing.  The capacity of the Quick-Press unit operated by two workers was 70 shirts an hour.

 

Under the revised setup, the shirt-pressing department consisted of:

  • the new Quick-Press unit operated by two people on a full-time basis with a capacity of 70 shirts an hour,
  • one old unit operated by four people on a full-time basis with a capacity of 90 shirts an hour, and
  • a second old unit operated only when needed by two workers on a part-time basis, with a capacity of 40 shirts an hour.

 

Forsythe continued his policy of using Unit C on a part-time basis rather than having his full-time employees work more than 27.5 hours a week.  Exhibit 1 shows the number of hours the presses of each unit were in operation in year 2009, the number of shirts each unit pressed, and the number of hours for which the operators of each unit were paid.

 

 

Exhibit 1

 

SELECTED DATA FROM THE PRESSING DEPARTMENT FOR 2009

 

Capacity                                                            Hours

in shirts           Hours in             Shirts            operators

Type of Unit              per hour          operation           pressed          were paid

 

  1. 2-worker unit 70               1,375*            96,250             2,080

(full time basis)

  1. 4-worker unit 90               1,375*          123,750             2,080

(full-time basis)

  1. 2-worker unit 40               900                 36,000             1,350**

(part-time basis)

 

* There were 250 working days in 2009, and the presses were in operation 5.5 hours a day, on average.

 

** Part-time employees were paid for lunch hours and rest periods.

 

 

The cost for purchasing the new Quick-Press unit was $91,700, plus freight of $1,200 and installation charges of $575.  There was no disruption of work while the unit installed over a weekend, but there was some slowdown while the operators became accustomed to the new methods and procedures used.  The slowdown resulted in an increase in labor cost for the installation period of about $500.  Power costs were increased by the cost of electricity for a five-horsepower motor that powered the body press.  The motor used one kilowatt of electricity an hour at a cost of 12 cents a kilowatt-hour.  Also, it was estimated that costs of operating the boiler and air compressor used to produce steam increased about $45 a month.

 

During 2009, the Quick-Press unit performed much as expected.  Forsythe was pleased with the results and, therefore, considered purchasing a second unit in February 2010.  About that time, the manufacturer of Quick-Press machines brought out a new model, Model 85, which was equipped with an automatic folding table.  The capacity of this unit, which also was operated by two workers, was expected to be 85 shirts an hour.  Forsythe believed that he could use the Model 85 unit to replace Unit B, the pressing unit currently being operated by four people.  The two Quick-Press units would then be operated on a full-time basis of 1,375 hours each year.  The remaining old unit (Unit C) would be operated by two workers on a part-time basis and only when necessary.  This arrangement would give Forsythe three units: one Quick-Press unit with potential capacity of 85 shirts per hour, one Quick-Press unit with a capacity of 70 shirts per hour, and one old unit with a capacity of 40 shirts per hour when operated by two people or 80 shirts per hour when operated by four people.

 

The Quick-Press Model 85 would cost $105,720, plus freight of $1,400 and installation of $640.  The body press of the second Quick-Press unit would have its own five-horsepower motor.  Costs of operating the boiler and air compressor would be increased about $45 a month if the Quick-Press Model 85 replaced the old equipment in Unit B.

 

A year-end balance sheet and an income statement for 2009 are shown in Exhibits 2& 3.

 

Assume the risk free rate is 2% and the inflation rate is 3%.

 

Required:

   
  A.      Is this decision a new project or equipment replacement  What types of cash flows are relevant for this type of decision Categorize and sum the relevant cash flows.
  B.      Pick a MACRS life and find the MACRS factors for this project. Explain your choice.

C.      Use your judgment to determine the estimated life of the project (number of years of cash flows to be included in the NPV analysis) and explain your choice.

  D.      Considering the risk of the project, determine a risk premium and explain your choice.
  E.       Develop a spreadsheet (use the template from the Stiles or Wet Water in class exercise or use the example in Appendix 12A of the textbook) to calculate the net present value of purchasing the new equipment.
  F.       Identify which of the pieces of information used in the NPV calculation are uncertain.  Explain why these uncertainties are important to John Forsythe’s decision.
  G.      Identify possible qualitative factors that Forsythe might consider in making his decision.  Identify as many factors as you can.
  H.      Write a memoto John Forsythe explaining whether he should purchase the new pressing machine.  Include the most important factors that Forsythe should consider in making his decision.  Provide Forsythe with any other suggestions you might have to help him improve the profitability.

 

 

Submission Requirements:

  • Submit a word document with answers to A – H to turnitin.com.
  • Submit your spreadsheet to digital drop box on Blackboard. Your name should be in the file name.
  • Submit a hard copy in class including the word document and spreadsheet.

 

 

Exhibit 2

 

Scrub Duds Laundry

 

Balance Sheet

December 31, 2009

(Figures rounded to hundreds of dollars)

 

ASSETS

 

CURRENT ASSETS:

Cash                                                                                        $   10,900

Accounts receivable                                                                     14,600

Prepaid expenses                                                                            7,200

Total current assets                                                               $   32,700

 

FIXED ASSETS:

Machinery and equipment (net)                                                160,700

Building (net)                                                                            121,800

Total Assets                                                                          $315,200

 

LIABILITIES AND OWNERS’ EQUITY

 

CURRENT LIABILITIES:

Accounts payable                                                                    $     8,500

Accrued expenses                                                                     2,900

Total Current Liabilities                                                        $11,400

 

LONG-TERM LIABILITIES:

Mortgage loan                                                                           83,500

Total Liabilities                                                                     $     94,900

 

OWNERS’ EQUITY:

Capital Stock                                                                             106,000

Retained earnings                                                                      114,300

Total Liabilities and Owners’ Equity                                    $315,200

 

 

 

 

Exhibit 3

 

SCRUB DUDS LAUNDRY

 

Income Statement

Year Ending December 31, 2009

(Figures rounded to hundreds of dollars)

 

Net Sales                                                                                    $348,500

Laundry operating costs:

            Productive labor                       $123,700

Productive supplies                                    33,000

Power                                                         11,200

Plant overhead                                           45,500

Total operating costs                                                   $213,400

 

Collection and delivery                                      48,400

Sales promotion                                                 12,000

Executive salaries                                               18,900

Office and Administrative                                 22,300

Total Costs                                                                  315,000

Income before taxes                                                                   $33,500

Federal income tax                                                                     10,100

Net income                                                                                 $23,400