Question

Based on the following:

• The estimated purchase price for the equipment required to move the operation in-house would be $500,000. 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 $25,000 per year starting in year 0 and through all 5 years of the project to support production.

• The current spending on this component (i.e. annual spend pool) is $875,000. The estimated cash flow savings of bringing the process in-house is 20% or annual savings of $175,000. This includes the additional labor and overhead costs required.

• Your company has access to a credit line and could borrow the funds at a rate of 6%.

• 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 five years for $25,000. (i.e. the terminal value).

Your colleague 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. She 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 14% discount rate should be used.

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): Show Calculations

o  Nominal Payback

o  Discounted Payback

o  Net Present Value

o  Internal Rate of Return

Answer 1

Nominal payback period=Total Initial investment/Undiscounted annual cash flows

ie.525000/175000=

3

yrs.

Discounted payback period
Year	C/fs	PV F at 6%	PV at 6%	Cumulative discounted c/f
0	-525000	1	-525000	-525000
1	175000	0.94340	165094	-359906
2	175000	0.89000	155749	-204156
3	175000	0.83962	146933	-57223
4	175000	0.79209	138616	81393
5	200000	0.74726	149452	230845
		NPV=	230845
	Discounted payback=3+(57223/138616)=
	3.41
	Years
	NPV=	230845
	IRR=	21%