Page 162 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 6: Capital Budgeting

Notes
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Case Study Mavis Machine Shop

he case is set in a metalworking 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
Tresulting from the oil crises of 1974 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 machinery or assorted machined metal parts for the
oil and gas drilling and production industry in the surrounding area. One of Mavis major
customer 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 8,400 bits per year. All Buckeye's rigs were busy.
Mavis knew, there were 30 rigs operating in the state and that it had resin up from 17 in
1972. Wells drilled was up even more, from 679 in 1972 to 1,474 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
mechanical keep. Mavis was considering replacing these manual lathes with an automatic
machine, capable of performing all four machinery 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 produced 8,400 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 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 functioning, and make necessary adjustments. It would have an output
of 8,400 drill its annually on a two-shift, 5-day basis. As it would be specially built by a
machine tool manufacturer, there was no catalogue 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 the
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 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 labour rate for lathe operations was $10 per hour
including fringe benefits. Pay rates for operators would not change as a result of machining

Contd...

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