Question

A-1 Chips is a manufacturer of prototype chips based in Dublin, Ireland. Next year, in 2018, A-1 Chips expects to deliver 525 prototype chips at an average price of $100,000. A-1 Chips' marketing vice president forecasts growth of 50 prototype chips per year through 2024. That is, demand will be 525 in 2018, 575 in 2019, 625 in 2020, and so on. 

Answer 1

1 - Cash Inflow and Outflow

2. Payback Period

Since information is not provided as to whether simple payback or discounted payback period should be calculated, i've shown below the example of discounted payback period as that is more relevant.

Discounted Payback Period - Option Modernise
Initial Investment = $ 34,800,000
Year	Discounted Cash Inflow	Cumulative Cash Inflow
Year 1	$               8,113,636	$          8,113,636
Year 2	$               8,078,512	$        16,192,149
Year 3	$               7,982,720	$        24,174,869
Year 4	$               7,837,579	$        32,012,448
Year 5	$               7,652,855	$        39,665,303
Year 6	$               7,436,944	$        47,102,247
Year 7	$             10,583,886	$        57,686,133

Simple Payback period =	Years before full recovery + (Unrecovered cost at the start of the year/Cash flow during the year)
=	4 + [($ 34,800,000 - $ 32,012,448) / $ 7,652,855]
=	4 + 0.36425
=	4.364 years

Discounted Payback Period - Option Replace
Initial Investment = $ 66,300,000 - $ 4,400,000 = $ 61,900,000
Year	Discounted Cash Inflow	Cumulative Cash Inflow
Year 1	$             12,886,364	$        12,886,364
Year 2	$             12,830,579	$        25,716,942
Year 3	$             12,678,437	$        38,395,379
Year 4	$             12,447,920	$        50,843,300
Year 5	$             12,154,535	$        62,997,835
Year 6	$             11,811,617	$        74,809,452
Year 7	$             20,051,653	$        94,861,105

Simple Payback period =	Years before full recovery + (Unrecovered cost at the start of the year/Cash flow during the year)
=	4 + [($ 61,900,000 - $ 50,843,300) / $ 12,154,535]
=	4 + 0.90967
=	4.91 years

3 - Net Present Value

The Net Present value of the Option to Modernise the Plant is $ 22,886,133

The Net Present Value ofthe option to replace the plant is $ 32,961,105

4 - A1 Chips should consider both quantitative (as calculated above) and qualitative factors while choosing between the two alternatives

Quantitative factors like payback period and net present value have already been calculated. The results should be interpreted as such – while comparing the two payback periods, it seems like the modernize option would be able to earn the full investment in the early part of the 5th year of operations whereas the replace option would be able to earn back its full investment only by the end of the 5th year. This isn’t a huge gap in the payback period of both alternatives; it is a matter of 6-8 months. The next step would be to analyze the net present value. As can be seen from the calculations in sub-part 3 of the question, the NPV of the replace option is $ 10,074,072 more than the NPV of the Modernize option. This means the firm will earn ~$10 M more if it goes with the replace option. This is a large benefit and therefore waiting 6-8 months more to earn back the cost of investment is affordable. Based on the quantitative factors, A1 Chips should elect to go with replacing the plant.

Qualitative factors to be considered:The firm should also take into account factors like redundancy of labor leading to layoffs, environmental impact of overhauling the plant, quality considerations(will the modernized/replaced plant continue to meet the standard set by the firm for its product) etc.