The CEO of Dynamic Manufacturing was at a conference and talked to a supplier ab
ID: 2801117 • Letter: T
Question
The CEO of Dynamic Manufacturing was at a conference and talked to a supplier about a new piece of equipment for its production process that she believes will produce ongoing cost savings. As the Operations Manager, your CEO has asked for your perspective on whether or not to purchase the machinery.
After talking to the supplier and meeting with your Engineers and Financial Analysts, you’ve gathered the following pieces of data:
• Cost of Machine: $153,000
• Estimated Annual After Tax Cash Flow Savings: $62,000 (which may or may not grow)
• Estimated machinery life: 3-5 years (after which there will be zero value for the equipment and no further cost savings)
• You seem to recall that Dynamic’s Finance organization recommends either a 10% or a 15%discount rate for all Cost Savings Projects
From your MBA class, you know that you need to understand the project financials to ensure that this investment will be economically attractive to Dynamic Manufacturing’s shareholders.
Calculate the Nominal Payback, the Discounted Payback, the Net Present Value and the IRR for each scenario assuming:
A. Alice (A) recommends using the base assumptions above: 3 year project life, flat annual savings, 10% discount rate.
B. Bill (B) recommends savings that grow each year: 3 year project life, 10% discount rate and a 10% compounded annual savings growth in years 2 & 3. In other words, instead of assuming savings stay flat, assume that they will grow by 10% in year 2, and then grow another 10% over year 3 in year.
C. Carla (C) believes we use a higher Discount Rate because of the risk of this type of project: 3 year project life, flat annual savings, 15% discount rate.
D. Danny (D) is convinced the machine will last longer than 3 years. He recommends using a 5 Year Equipment Life: 5 year project and savings life, flat annual savings, 10% discount rate. In other words, assume that the machine will last 2 more years and deliver 2 more years of savings.
Discussion – in a Word document in paragraph form, respond to the following:
1) Which person’s scenario would you present to management and why? From a strictly financial (numbers) perspective, would you recommend this purchase to management?
2) In your opinion, which person’s scenario is based on the most aggressive assumptions? If you were to select this scenario as the basis for your proposal, how would you justify the more aggressive assumptions?
Explanation / Answer
Cost of Machine is $153000 with with annual after tax savings $ 62000. Uselful life of machine is 3-5 years.
Discount rate is either 10% or 15%.
A. Alice Recommneds 3 Years life, Flat annual savings and 10% discount Rate.
Now with 3 years life, annual depreciation is 153000/3 = $51000.
However, as Post Tax Cashflow is already provided. Depreciation is not added back.
Here Cash flow is as under :
1/1.10 = 0.909
Total Cash Flow present value = 154132 $
NPV = 154132 - 153000 = $ 1132.
Payback period = 2 Years + 29000/62000 = 2.4677 Years
Discounted Pay Back = 2 Years + 45430/46562 = 2.9757 Years.
IRR = 10.44%
B.Bill (B) recommends savings that grow each year: 3 year project life, 10% discount rate and a 10% compounded annual savings growth in years 2 & 3. In other words, instead of assuming savings stay flat, assume that they will grow by 10% in year 2, and then grow another 10% over year 3 in year.
Here Cash flow is as under :
1/1.10 = 0.909
NPV = 169031 - 153000 = $ 16031.
Payback Period = 2 Years + 22800/75020 = 2.3039 Years.
Discounted Payback period = 2 Years + 40309/56340 = 2.7155 Years.
IRR = 15.69%
C. Carla (C) believes we use a higher Discount Rate because of the risk of this type of project: 3 year project life, flat annual savings, 15% discount rate.
Here Cash flow is as under :
1/1.15 = 0.869
Total Cash Flow present value = 141484 $
NPV = 141484 - 153000 = $ -11516.
Payback period = 2 Years + 29000/62000 = 2.4677 Years
Discounted Pay Back is Not Applicable as it goes beyond useful life of machine.
IRR = 10.44%
D. Danny (D) is convinced the machine will last longer than 3 years. He recommends using a 5 Year Equipment Life: 5 year project and savings life, flat annual savings, 10% discount rate. In other words, assume that the machine will last 2 more years and deliver 2 more years of savings.
Here Cash flow is as under :
1/1.10 = 0.909
1/(1.10)^5 = 0.621
Total Cash Flow present value = 234980 $
NPV = 154132 - 153000 = $ 81980.
Payback period = 2 Years + 29000/62000 = 2.4677 Years
Discounted Pay Back = 2 Years + 45430/46562 = 2.9757 Years.
IRR = 29.31%
Now we have data pertaining to all 4 with their respective assumptions.
1) Based on Pure Financial perspective, we should make presentation of Danny to Management as it results into Highest NPV and IRR among all available presentations. It has more number of usefule life projected for the machine resulting in more years of cost savings and higher cash inflows.
2) In terms of Discounting Factors,Carla's assumption is more aggressive as she has assumed higher risk for the project. However, she has assumed flat rate of savings over the year which is not realistic. In terms of useful life, Danny's assumption is more aggressive as he has assumed 5 years of useful life. However, he has also assumed flat rate of savings.
With combination of all 4 presentations, It is advisable to use 5 years of Useful life for machine with 10% annual growth rate in savings over the years. However Firm should assume higher discount rate of 15% to factor higher risk associated with project in realistic terms.
Year Cash Flow Discount Facor at 10% Discounted Cash Flow 1 620001/1.10 = 0.909
56358 2 62000 1/(1.10)^2 = 0.826 51212 3 62000 1/(1.10)^3 = 0.751 46562Related Questions
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