Question

Case Analysis 2: 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.

Calculate the Nominal Payback, the Discounted Payback, the Net Present Value and the IRR for each scenario, assuming:

A. Ann recommends using the base assumptions above: 3 year project life, flat annual savings, 10% discount rate.

B. Bob 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% in year 3.

C. Cassidy 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 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.

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?

***I'd appreciate if this could be broken down step by step for me, I'm having a hard time understanding where I'm going wrong with this question, thank you.

Answer 1

A) Project Life – 3year, Savings – Flat, Discount rate = 10%

Year	After Tax Cash Flow Savings	PV Factor @ 10%	Present worth of after tax cash flow savings	Cumulative PW Cash Flows
1	60000	0.90909	54545.40	54545.40
2	60000	0.82644	49586.40	104131.80
3	60000	0.75131	45078.60	149210.40

1. Nominal Payback Period = Total Investment / Annual Cash Inflows

= 140,000 / 60,000 = 2.33 years

2. Discounted Payback Period = From the cumulative PW of cash flow, discounted payback period will fall between 2 to 3 years, A sum of $ 104,131.80 will be recovered in 2 years and rest balance of $ 35,868.2(140,000 – 104,131.80) in a fraction of third year:

Discounted Payback Period = 2 years + (35868.2 / 45078.60) years = 2.795 years.

3. Net Present Value = PW of Cash Flow savings – PW of Intimal Investment

= 149210.40 – 140000 = $9,210.4

4. Internal Rate of Return = 13.70% (using excel)

B) Project Life = 3 years, Savings grow @ 10%, Discount Rate 10%:

Year	After Tax Cash Flow Savings	Cumulative after tax cash flow savings	PV Factor @ 10%	Present worth of after tax cash flow savings
1	60000	60000	0.90909	54545.40
2	66000	126000	0.82644	54545.04
3	72600	198600	0.75131	54545.11

1. Nominal Payback Period: Cumulative cash flow savings shows that payback period lies between 2 to 3 years.

= 2 years + (14000/72600) years = 2.19 years.

2. Discounted Payback Period: As the discounted cash flow savings are equal throughout the year,

= 140,000 / 54545 = 2.57 years

3 Net Present Value = (54545.40 + 54545.04 + 54545.11) – 140,000 = $ 23,636.3

4. Internal Rate of Return = 19.05%% (using excel)           

C) Project Life = 3 years, Savings = Flat, Discount Rate = 15%

Year	After Tax Cash Flow Savings	PV Factor @ 15%	Present worth of after tax cash flow savings	Cumulative Value of PW
1	60000	0.86956	52173.60	52173.6
2	60000	0.75614	45368.40	97542
3	60000	0.65751	39450.60	136992.6

  

1. Nominal Payback Period: As the nominal cash flow savings are equal throughout the 3 years,

= 140,000/ 60,000 = 2.33 years

2. Discounted Payback Period: Cumulative PW of cash flow savings shows that discounted payback period will be greater than 3 years. Up to 3 years only $ 136,992.6 are recovered from initial investment of $ 140,000.

3. Net Present Value = 136,992.6 – 140,000 = ($ 3,007.4)

4. Internal Rate of Return = 13.70 %

D) Project Life = 5 Years, Savings = flat, Discount Rate = 10%

Year	After Tax Cash Flow Savings	PV Factor @ 15%	Present worth of after tax cash flow savings	Cumulative Value of PW
1	60000	0.90909	54545.40	54545.4
2	60000	0.82644	49586.40	104131.8
3	60000	0.75131	45078.60	149210.4
4	60000	0.68301	40980.60	190191
5	60000	0.62092	37255.20	227446.2

1. Nominal Payback Period = 140,000 / 60,000 = 2.33 years
2. Discounted Payback Period = 2 years + (35,868.2 / 45,078.60) = 2.795 years.
3. Net Present Value = 227,446.2 – 140,000 = $ 87,446.2
4. Internal Rate of Return = 32.27 % (using excel)