Agency Problems

Qus 2. Marginal analysis and the goal of the firm Ken Allen, capital budgeting analyst for Bally Gears, Inc., has been asked to evaluate a proposal. The manager of the automotive division believes that replacing the robotics used on the heavy truck gear line will produce total benefits of $560,000 (in today’s dollars) over the next 5 years. The existing robotics would produce benefits of $400,000 (also in today’s dollars) over that same time period. An initial cash investment of $220,000 would be required to install the new equipment. The manager estimates that the existing robotics can be sold for $70,000. Show how Ken will apply marginal analysis techniques to determine the following:
a. The marginal (added) benefits of the proposed new robotics.
b. The marginal (added) cost of the proposed new robotics.
c. The net benefit of the proposed new robotics.
d. What should Ken Allen recommend that the company do? Why?
e. What factors besides the costs and benefits should be considered before the final decision is made?
f. Now assume that Bally Gears acquired the robotics equipment. During the next fiscal year the company generated before-tax operating profits of $345,000. The company’s tax rate is 25 percent. The total capital invested in the business is $1,500,000. Bally’s cost of financing (the cost of the capital) is 13.6 percent. What was Bally’s economic value added (EVA) for the year? What does your answer for EVA mean?

Ans. Benefits with new robotics | $560,000 | Less: benefits with old robotics | $400,000 | a. Marginal (added ) benefit | $160,000 | Cost of new robotics | $220,000 | Less: proceeds from sale of old robotics | $70,000 | b. Marginal (added )costs | $150,000 | Net benefit [ (a)-(b) ] | $10,000 |

Because the marginal (added) benefits of $160,000 the marginal (added) costs of 150,000 Ken Allen recommends that the firm purchase new robotics to replace the old one. This firm will experience a net benefits of $10,000