11-63Note: The solution below draws on net present value analysis, which is

covered in other courses but not in this book.

(a)
Year

Strathcona Paper
Outflow
Savings

Depreciation

50,000,000

16,000,000

10,000,000

16,000,000

10,000,000

16,000,000

10,000,000

16,000,000

10,000,000

16,000,000

10,000,000

Year

Taxes

NCF

PV

(50,000,000)

(50,000,000)

2,100,000

13,900,000

12,410,714

2,100,000

13,900,000

11,080,995

2,100,000

13,900,000

9,893,745

2,100,000

13,900,000

8,833,701

2,100,000

13,900,000

7,887,233

Net present value

$106,388

Since the net present value of this project is positive, from the point of
view of the company, it should be accepted.
(b)

The manager is evaluated based on the after-tax return on investment

of assets managed. The current investment base is $50,000,000 and
the current net income after taxes is $7,000,000, which yields a return
on investment of 14% = $7,000,000 $50,000,000.
With the new investment in the first year, income after taxes will
increase to $10,900,000 = ($7,000,000 + $16,000,000 $10,000,000
$2,100,000)

and the new investment level will increase to $90,000,000 =

($50,000,000 + $50,000,000 $10,000,000). Therefore, the return on
investment for the first year of operations with the new trucks will be
12.1% = $10,900,000 $90,000,000.
Therefore, evaluated by the first year of operations, the manager
would prefer not to make this investment. However, the return on
investment numbers for years 2 through 5 inclusive are 13.6%, 15.6%,
18.2%, and 21.8%, respectively. Note that each year the income level
will remain the same while the investment level will be $80,000,000
in year 2, $70,000,000 in year 3, $60,000,000 in year 4, and
$50,000,000 in year 5. Therefore, the managers attitude about this
investment will reflect how long the manager expects to remain in her
current position.
(c)

The after-tax residual income currently is $1,000,000 = [$7,000,000

($50,000,000 12%)]. The after-tax residual income in the first year
after the investment in the new trucks is $100,000 = [$10,900,000
($90,000,000 12%)]. If evaluated by the first year of operations, the
manager would not make the investment. The residual income
numbers in years 2 through 5 are: $1,300,000, $2,500,000,
$3,700,000, and $4,900,000. Therefore, the managers attitude about
this investment will reflect how long the manager expects to remain in
his current position.

11-70 The major issue in choosing a transfer price is motivating the managers of
the two divisions to behave in a way that makes the organizations profits as
large as possible.
For existing home kits, the manager of the sales division will want to buy
home kits as long as the sales division can realize a profit on selling the
home kits to the final customers. Therefore, the transfer price must not
exceed $35,000, which is the selling price of $40,000 less the selling
divisions cost of $5,000 per home.
The manager of the manufacturing division will want to sell existing home
kits as long as the manufacturing division can realize a profit on selling the
homes to the selling division. Therefore, the transfer price must exceed
$30,000 ($33,000 1.1), which is the variable cost of making the home kits.
Therefore, any transfer price between $30,000 and $35,000 for the existing
homes will cause the manufacturing division to make, and the selling
division to buy and sell, all the home kits that the manufacturing division is
capable of making.
Turning to the proposal to make cottage kits, recall that the manufacturing
division is currently operating at capacity and will therefore have to give up
production of home kits in order to manufacture cottage kits. From the
companys perspective, the companys contribution margin per home kit
is $5,000 = ($40,000 $30,000 $5,000). Let P = the price at which the
company is indifferent (with respect to profit) between selling all home kits
or all cottage kits. Home kits require 10 machine hours (mh) per unit and
cottage kits require 13 mh per unit, and 5,000 mh are available per year.
Assuming that the selling cost of the cottage kit is the same as the selling
cost of the home kit ($5,000 per unit), equating the total contribution
margins for the two options requires the following:
(5,000 mh 13 mh per cottage) (P $30,000 $3,000 $5,000) =
(5,000 mh 10 mh per home) ($40,000 $30,000 $5,000)
Thus, P $38,000 = ($5,000 10 mh per home) (13 mh per cottage),
so
P = $38,000 + $6,500 = $44,500.

Note that $6,500 is the opportunity cost of producing and selling a cottage
kit instead of a home kit. This opportunity cost is the $500 of contribution
margin per mh for home kits, multiplied by the 13 mh required per cottage
kit. (If one wishes to take into account only production in whole numbers,
then 5,000 13 = 384.62 will have to rounded down to 384, and the necessary
price will be approximately $44,511.)
The analysis from the manufacturing divisions point of view is similar.
Let TP = the transfer price for cottage kits at which the division is indifferent
between transferring home kits at variable cost plus 10% ($30,000 + $3,000)
or cottage kits at TP per unit. Assuming production of either all home kits or
all cottage kits and equating the total contribution margins for the two
options requires the following:
(5,000 mh 13 mh per cottage) (TP $30,000 $3,000) =
(5,000 mh 10 mh per home) ($33,000 $30,000)
TP $33,000 = ($3,000/10 mh per home) (13 mh per cottage), so
TP = $33,000 + $3,900 = $36,900.
This transfer price incorporates the original variable cost of $30,000, the
incremental manufacturing cost of $3,000, and the $3,900 opportunity cost
to the manufacturing division for making a cottage kit instead of a home kit,
given the existing transfer price for home kits.
Thus, the manufacturing division will not be willing to accept a transfer
price less than $36,900 per cottage kit. Assuming a selling price per cottage
kit of $44,500, the selling division will not be willing to pay more than
$39,500 ($44,500 $5000). Therefore, a transfer price between $36,900 and
$39,500 should induce both managers to be willing to engage in the transfer.