Flowton Products enjoys a steady demand for stainless steel infiltrators used in
ID: 2482726 • Letter: F
Question
Flowton Products enjoys a steady demand for stainless steel infiltrators used in a number of chemical processes. Revenues from the infiltrator division are $50 million a year and production costs are $47.5 million. However, the 10 high-precision Munster stamping machines that are used in the production process are coming to the end of their useful life. One possibility is simply to replace each existing machine with a new Munster. These machines would cost $800,000 each and would not involve any additional operating costs. The alternative is to buy 10 centrally controlled Skilboro stampers. Skilboros cost $1.25 million each, but compared to the Munster, they would produce a total saving in operator and material costs of $500,000 a year. Moreover, the Skilboro is sturdily built and would last 10 years, compared with an estimated 7-year life for the Munster.
Analysts in the infiltrator division have produced the accompanying summary table, which shows the forecast total cash flows from the infiltrator business over the life of each machine. Flowton's standard procedures for appraising capital investments involve calculating net present value, internal rate of return, and payback, and these measures are also shown in the table.
As usual, Emily Balsam arrived early at Flowton's head office. She had never regretted joining Flowton. Everything about the place, from the mirror windows to the bell fountain in the atrium, suggested a classy outfit. Ms. Balsam sighed happily and reached for the envelope at the top of her in-tray. It was an analysis from the infiltrator division of the replacement options for the stamper machines. Pinned to the paper was the summary table of cash flows and a note from the CFO, which read, "Emily, I have read through 20 pages of excruciating detail and I still don't know which of these machines we should buy. The NPV calculation seems to indicate that the Skilboro is best, while IRR and payback suggest the opposite. Would you take a look and tell me what we should do and why. You also might check that the calculations are OK.
Can you help Ms. Balsam by writing a memo to the CFO? You need to justify your solution and also to explain why some or all of the measures in the summary tables are innapropriate.
Cash Flows (millions of dollars) Year: 1-7 10 Munster Investment Revenues Costs Net cash flow NPV at 15% IRR Payback period Skilboro Investment Revenues Costs Net cash flow NPV at 15% IRR Payback period 8.0 50.0 47.5 2.5 8.0 $2.40 million 24.5% 3.2 years -12.5 50.0 50.0 50.0 50.0 47.0 47.0 47.0 47. 3.0 3.0 3.0 3.0 -12.5 $2.56 million 20.2% 4.2 yearsExplanation / Answer
Memo: Decison Analysis for Buying Munster Or Skilboro
This is with regard to analysis on Purchasing Machines Munster or Skilboro, the decision cannot be directly based on NPV, IRR, or Payback Period because of unequal lives of the machines. Although these three are mostly used methods but due to unequal lives of machines all three methods are inappropriate in our case.
If we consider only NPV then Buying Skilboro is suggested since NPV of Munster $2.4 Million is less than NPV for skilboro of $2.56 Million. Whereas if we go with IRR then Munster have higher IRR of 24.5% as compared to Skilboro with 20.2% IRR. Similarly Payback period prioritize skilboro which has payback in 4.2 years as compared to Munster with payback in 3.2 years.
However since this machines have an unequal lives so decision has to be based on annual net present value (also called equivalent annual annuity).
Annual net Present Value =
Net Present Value/
Annuity Discount Factor for the Project Life
Annual Present value for Munster = $2.4 million/4.1604 = $ 0.5769 Million
Annual Present Value for Skilboro = $2.56 Million/5.0188 = $ 0.5101 million
Note : Annuity factor for 7 years at 15 % = 4.1604 and for 10 years = 5.0188
So this is the net present value added by each machine per year. The project with higher annual net present value should be accepted. Annual net present value method is also called the equivalent annual annuity approach. Incremental NPV per year for Munster = 0.5769-0.5101 = $ 0.0668 Million or $ 66800
Hence, based on above analysis it is recommended to Purchase Munster Stamping machines.
Annual net Present Value =
Net Present Value/
Annuity Discount Factor for the Project Life
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