Question

The company has been growing steadily over the past 5 years, and the financials and future prospects look good. Your CEO has asked you to run the numbers. After doing some digging into the business, you have gathered information on the following:

• The estimated purchase price for the equipment required to move the operation in-house would be $750,000. Additional net working capital to support production (in the form of cash used in Inventory, AR net of AP) would be needed in the amount of $35,000 per year starting in year 0 and through all years of the project to support production as raw materials will be required in year o and all years to run the new equipment and produce components to replace those purchased from the vendor..

• The current spending on this component (i.e. annual spend pool) is $1,200,000. The estimated cash flow savings of bringing the process in-house is 20% or annual savings of $240,000. This includes the additional labor and overhead costs required.

• Finally, the equipment required is anticipated to have a somewhat short useful life, as a new wave of technology is on the horizon. Therefore, it is anticipated that the equipment will be sold after the end of the project (the last year of generated cash flow) for $50,000. (i.e. the terminal value).

As part of your research, you have sought input from a number of stakeholders. Each has raised important points to consider in your analysis and recommendation. Some of the points and assumptions are purely financial. Others touch on additional concerns and opportunities.

Question:

Eva from Engineering believes we use a higher Discount Rate because of the risk of this type of project. As such, she is recommending a 5-year project life and flat annual savings. Eva suggests that even though the equipment is brand new, the updated production process could have a negative impact on other parts of the overall manufacturing costs. She argues that, while it is difficult to quantify the potential negative impacts, to account for the risk, a 12% discount rate should be used. Being an engineer, Eva feels that the stated terminal value is low based on her experience, and is recommending a $75,000 terminal value,

Using the data presented above (and ignoring the extraneous information), for this profit and supply chain improvement project, calculate each of the following (where applicable):

• Nominal Payback

• Discounted Payback

• Net Present Value

• Internal Rate of Return

Answer 1

Year	0	1	2	3	4	5
1.Purchase price of the Eqpt.	-750000
2.NWC reqd.& recovered	-35000					35000
3.Salvage value of the Eqpt.						75000
4.Annual savings		240000	240000	240000	240000	240000
5. Total FCFs(sum 1 to 4)	-785000	240000	240000	240000	240000	350000
6. PV F at 12%(1/1.12^yr.n)	1	0.89286	0.79719	0.71178	0.63552	0.56743
7.PV at 12%(5*6)	-785000	214285.71	191326.53	170827.26	152524.34	198599.40
8.NPV(sum of row 7)	142563.24	(Ans.iii)
9.IRR(of FCF row 5)	18.72%	(Ans.iv)
10.Nominal payback period(NPBP)
Cumulative nominal FCFs	-785000	-545000	-305000	-65000	175000	525000
NPBP=
3+(65000/240000)=	3.27	Years	(Ans.i)
11. Discounted Payback period(DPBP)
Cumulative disounted FCFs	-785000	-570714.29	-379387.76	-208560.50	-56036.16	142563.24
DPBP=
4+(56063.16/198599.40)=	4.28	Years	(Ans.ii)