Question

You are the CEO (Chief Executive Officer) of a large industrial grade Group of Bakeries, the operation has been exceptionally profitable, and the Group now has a considerable amount of cash. The Board of Directors has decided to invest the money in expanding the operation rather than distributing dividends to the shareholders. The Marketing Department has identified a new market segment, of which your Group of Bakeries can get a considerable share. You decide, therefore, to build a new Production Line; you issue an RFP (Request For Proposal) for the implementation of this new Production Line. Three Contractors submit their Proposals: one Contractor proposes a low-price Line, another proposes a medium priced one, and a third proposes a state-of-the art computer-controlled Line. Their proposals are summarized as follows:

Low Price Option • Price: $ 1,000,000 • Operation & Maintenance: the anticipated O&M cost is $ 25,000 per year and is expected to increase, due to wear and tear, by a $ 1,000 per year • Overhaul need : it is expected that every 5 years there will be the need of a major overhaul at a cost of $ 20,000. After each overhaul, the cost of O&M decreases to its original value ($ 25,000/yr) and then increases again at the same rate ($ 1,000/yr). No overhaul is done at the end of useful life. • Anticipated Yearly Revenues: it is anticipated that the new production line will produce sales revenues in the amount of $ 200,000 per year, and that such revenues will increase by $ 10,000 per year • Useful Life: the useful life of this production line is expected to be 20 years • Salvage Value: at the end of its useful life, the line will be sold on the used market for an anticipated price of $ 50,000

Medium Price Option • Price: $ 2,000,000 • Operation & Maintenance: the anticipated O&M cost is $ 20,000 per year and is expected to increase, due to wear and tear, by a $ 1,500 per year • Overhaul need: it is expected that after 10 years there will be the need of a major overhaul at a cost of $ 40,000. After the overhaul, the cost of O&M decreases to its original value ($ 20,000/yr) and then increases again at the same rate ($ 1,500/yr). ). No overhaul is done at the end of useful life. • Anticipated Yearly Revenues: it is anticipated that the new production line will produce sales revenues in the amount of $ 350,000 per year, and that such revenues will increase by $ 6,000 per year • Useful Life: the useful life of this production line is expected to be 20 years • Salvage Value: at the end of its useful life, the line will be sold on the used market for an anticipated price of $ 120,000

State-of-the-Art Option • Price: $ 4,000,000 • Operation & Maintenance: the anticipated O&M cost is $ 30,000 per year and is expected to increase, due to wear and tear, by a $ 2,500 per year • Overhaul need: this production line will not need any overhaul during its useful life • Anticipated Yearly Revenues: it is anticipated that the new production line will produce sales revenues in the amount of $ 500,000 per year, and that such revenues will increase by $ 5,000 per year • Useful Life: the useful life of this production line is expected to be 20 years • Salvage Value: at the end of its useful life, the line will be sold on the used market for an anticipated price of $ 120,000

Answer the following questions, and show the calculations in support of your answers: A) If the cost of capital for your Group of Bakeries is 7% what proposal should you choose? B) If the cost of capital for your Group of Bakeries is 14% what proposal should you choose? C) What cost of capital would make the Low-Price option economically identical to the Medium-Price Option? D) What cost of capital would make the Medium-Price option economically identical to the State-of-the-art Option? E) What cost of capital would make none of the three options economically feasible?

Answer 1

Following information are given in the question:

Step 1 : Find the yearly cash-flows of all the three options

Yearly cash-flows of Low Price Option

Workings:

Yearly cash-flows of Medium Price Option

Workings:

Yearly cash-flows of State of the art Option

Workings:

Step 2: Calculate NPV and IRR of all the three options:

A) If the cost of capital for your Group of Bakeries is 7% what proposal should you choose?

At cost of capital of 7%, NPV is highest for Medium Price Option. Hence, Medium Price Option is to be chosen.

B) If the cost of capital for your Group of Bakeries is 14% what proposal should you choose?

At cost of capital of 14%, NPV is highest for Low Price Option. Hence, Low Price Option is to be chosen.

C) What cost of capital would make the Low-Price option economically identical to the Medium-Price Option?

To find the cost of capital at which Low-Price option would be economically identical to the Medium-Price Option, IRR of the differential annual cash flows of Low-Price option and Medium Price option is to be determined. IRR of this differential annual cash flow is 11.4%.

Thus, at cost of capital of 11.4%, the Low-Price option is economically identical to the Medium-Price Option

D) What cost of capital would make the Medium-Price option economically identical to the State-of-the-art Option?

To find the cost of capital at which Medium-Price option would be economically identical to the State-of-the-art Option, IRR of the differential annual cash flows of Medium-Price option and State-of-the-art option is to be determined. IRR of this differential annual cash flow is 1.6%.

Thus, at cost of capital of 1.6%, the Medium-Price option is economically identical to the State-of-the-art Option

E) What cost of capital would make none of the three options economically feasible?

IRR is the rate at which NPV of the cash-flows is zero. Thus, for a project to be not economically feasible, the cost of capital should be worse than the IRR.

Of all the 3 projects, Low Price option has the highest IRR of 20.9%. Thus, at a cost of capital higher than 20.9%, none of the three options economically feasible as the NPV will be negative.

Note:

All the cash-flows are before tax as tax rate is not given in the question. Since the cash-flows are before tax, depreciation is not to be considered (as depreciation is considered for cash-flow decisions only for the tax benefit it offers.

Workings: