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 Sales is convinced that this capability would allow new revenue stream that could significantly offset operating expenses. He recommends savings that grow each year: 5-year project life, 10% discount rate, and a 10% compounded annual savings growth in years 2 through 5. 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 2 in year 3, and so on.

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

Answer to Question No. 1

Nominal Payback

Period	Cash Flow	Cumulative Cash Flow
Year 0	-500000	-500000
Year 1	175000	-325000
Year 2	192500	-132500
Year 3	211750	79250
Year 4	232925	312175
Year 5	256218	568393

Nominal Payback Period = A +B/C

A = Last period with a negative cumulative cash flow;

B = Absolute value of cumulative cash flow at the end of the period A; and

C = Cash flow during the period after A.

Nominal Payback = 2 + 132500/211750 = 2.63 Years

Answer to Question No. 2

Discounted Payback

Discounted Cash Inflow (DCF) = Actual Cash Inflow/ (1 + i) n

Where,

i is the discount rate = 10%

n is the year for corresponding cash flow

Period	DCF	Cumulative DCF
Year 0	-500000	-500000
Year 1	159091	-340909
Year 2	159091	-181818
Year 3	159091	-22727
Year 4	159091	136364
Year 5	159091	295455

Discounted Payback Period = A +B/C

A = Last period with a negative discounted cumulative cash flow;

B = Absolute value of cumulative discounted cash flow at the end of the period A; and

C = discounted Cash flow during the period after A.

Discounted Payback = 3 + 22727/159091 = 3.14 Years

Answer to Question No. 3

Net Present Value

NPV = Present value of cash flows – initial investment

	A	B	C	D	E	F= A+B+C+D+E	G = 1/(1+i)^n	H = FXG
Period	Purchase Price	Working capital	Annual Savings	Terminal Value	Release of Working Capital	Net Cash Flow	Discounting Factor @ 6%	DCF
Year 0	-5,00,000	-25,000				-5,25,000	1.00	-5,25,000
Year 1			1,75,000			1,75,000	0.94	1,65,094
Year 2			1,92,500			1,92,500	0.89	1,71,324
Year 3			2,11,750			2,11,750	0.84	1,77,789
Year 4			2,32,925			2,32,925	0.79	1,84,498
Year 5			2,56,218	25,000	25,000	3,06,218	0.79	2,42,553
							Net Present Value (NPV)	4,16,259

Answer to Question No. 4

Internal Rate of Return

The IRR is a discount rate at which the present value of all cash flows from a particular project would be zero.

IRR calculation is a tedious task and can be computed on trial and error method.

For the above Cashflows the IRR works out to 22%.