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: $140,000 • Estimated Annual After Tax Cash Flow Savings: $60,000 (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 JWMI MBA, 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. Ann (A) recommends using the base assumptions above: 3 year project life, flat annual savings, 10% discount rate. B. Bob (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. Cassidy (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. David (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. In an MS Word document, in paragraph form, respond to the following questions: 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? 3) In SIMPLE English (as in talking to a non-Finance and non-MBA person), explain why there is value to management in running all 4 of these scenarios. 4) Beyond financial measures, what other factors would you want to consider, before making a recommendation to management? 5) If you were the CEO, would you approve this proposal? Why or why not?

Answer 1

The calculations are as below:

Now we can answer the other parts:

(a) It is prudent to present the conservative scenario but also at the same be realistic about the assumptions lest we end up rejecting profitable projects also. In this case we should be go with 3 year life for the machine (& cost saving) and look at constant estimate of the annual cost savings. Anything above this (if realised) would only better the prject returns. The problem is with the discount rate since with an IRR of 13.7% for 3 years and constant savings, at 10% discount rate this is a profitable project but at 15% it is not. However since most estimates are at 10% discount rate and there seems to be consensus on the cost savings to be at $60000 and it may increases from here, we will present Ann recommendation - 3 year life and flat cost savings with 10% discount rate.

(b) The most aggressive is David recommendation with 5 years of usable life which essentially increases the number of years cost savings will be realised and hence increases the project NPV & IRR - note that the payback remains unchanged. This can be justified only with the inputs from the engineering team where they can confirm that the machine is capable of delivering cost savings over 5 years and will be able to perform at same rate during its entire life.

(c) By running the various scenarios, the management can isolate the impact of the differing assumptions on the final outcome and they can use their judgement (basis their experience and knowledge) and discard the weak assumptions and base their decisions on stronger estimates.

(d) We should also consider technological obsolescence and impact (if any) on the over production process prior to finalising the decision - even these will have to quantified if possible .

(e) Yes - since the estimates point to life between 3 and 5 years and cost savings at $60000 which may increase, this seems to be reasonable investment to make . In the worst case also (with 15% discount rate), the discounted payback in 3.08 years only hence if the machine was to perform even marginally better even in worst case, the project should break even. If on the other hand the discount rate (hence risk) of the project turns out to be more like 10%, then it turns out to be a profitable project. Hence as CEO, we should invest in this project.