Question

Is there an expert that can assist in solving the attached net present value problem? There are several variables that I do not understand how to integrate. Thank you

The CNC machines were breaking down creating bottlenecks.

French believed the key to relieving this bottleneck would be increasing capacity. It not only would prevent downtime but also would allow the company to take on new business. If capacity increased, French estimated that sales revenues would rise by at least $50,000 per month due to unmet demand and increased efficiency. The company’s margins on the additional revenues were expected to be 35%.

French saw three viable options to increase capacity:

1. Purchase an additional CNC machine for cash,

2. Finance the purchase of an additional CNC machine, or

3. Add a third shift (a night shift) to better utilize the two CNC machines Peregrine already owned. French considered the details of each option, keeping in mind that for long-term projects he would use a discount rate of 7%.

OPTION 1: PURCHASE A NEW CNC MACHINE WITH CASH Although it would be costly, the idea of adding a third CNC machine appealed to French. It would provide him peace of mind that if there were a breakdown, jobs would continue on schedule. French’s preliminary research revealed that the cost of the new equipment would be $142,000. He also estimated that there would be increased out-of-pocket operating costs of $10,000 per month if a new machine were brought online. After five years, the machine would have a salvage value of $40,000. Although Peregrine did not have the cash readily available to make the purchase, French believed that with a small amount of cash budgeting and planning, this option would be feasible.

OPTION 2: FINANCE THE PURCHASE OF A NEW CNC MACHINE The company selling the CNC machine also offered a leasing option. The terms of the lease included a down payment of $50,000 and monthly payments of $2,200 for five years. After five years, the equipment could be purchased for $1. The operating costs and salvage values would be the same as option 1, the purchasing option. The company had the necessary cash on hand to make the down payment for the lease. With both the leasing and purchasing options, the company had sufficient space to operate the new equipment, and French believed he had almost all of the right employees in place to execute this plan.

OPTION 3: ADD A THIRD SHIFT French and one of his co-investors had extensive experience in the trucking industry and had seen firsthand the effect of utilizing equipment around the clock. French believed adding a third shift could unlock a lot of value at Peregrine, and it could be done at a low cost. Adding a third shift would involve moving several existing employees to work the night shift and would also mean hiring some new employees. Although French believed that in time he may add a full third shift to increase overall capacity, his initial plan was for the night shift to run as a “skeleton crew” with the primary purpose of keeping the CNC machines operational for 24 hours. He believed that adding a third shift would produce the same increase in revenue as adding a new CNC machine to his existing shifts. He estimated that adding a third shift would create $12,000 in additional monthly out-of-pocket operating costs, but no new machinery would need to be purchased. Based on his trucking experience, French knew this option would be difficult to execute, as there were major safety and supervision challenges associated with running a night shift. MOVING FORWARD French wanted to get moving on a solution and arranged a conference call with his two co-owners. He knew his coowners would be eager to learn the numbers behind each option, but he also knew that nonfinancial information would be just as crucial in making a recommendation. Before the call, French sat down at his desk to fully analyze the options.

ASSIGNMENT QUESTIONS

2. Compute and compare the net present value and payback period of each option.

4. Rounding to the nearest 1%, at what discount rate does leasing produce a higher net present value than paying cash?

Answer 1

OPTION1

initial investmentr   = ($142000)

Annual Increase in revenues= 50000 * 12= $600000

margin = 35% of 600000= $210000

net cash inflow every year= 210000- (10000 * 12 , out of pocket costs)= $90000

salvage value = $40000 received after 5 yrs

PAY BACK PERIOD

90000 is recovered in the first year, at the end of 2nd year, 90000 + 90000= 180000 is recovered.

So the initial investment of 142000 is recovered between first year and second year

Pay back period = 1yr + ( balance to be recovered/t recd in 2nd year = 1 yr + (142000-90000)/90000 = 1yr + 0.57 = 1.57 yrs

NET PRESENT VALUE

NPV= present value of cash inflows - initial investment

= 90000 * P/A 7%,5 yrs + 40000 * P/F 7% 5yrs - 142000

= (90000 * 4.1 + 40000 * 0.713 ) - 142000 = $255520

OPTION 2

cash inflow= $90000 per year

outflow in the begining= 50000

outflow every year= 2200 *12= 26400. So outflow for 5 years= 22400 * 5=112000

So total outflow= 50000 + 112000= (162000)

PAYBACK

out of 162000 , an amount of 90000 is recovered in the first year and the balance is recovered in the second year

So payback period= 1 yr + (162000-90000)/90000= 1yr +0.8= 1.8 yrs

NPV

NPV= ( 90000 * P/A 7% 5yrs) - (26400 * P/A 7% ,5yrs) - 50000

90000 * 4.1 - (26400 * 4.1) - 50000

369000- 108240-50000= 210760

OPTION 3

CASH INFLOW =210000 every year

cash outflow = 12000 * 12= 144000 every year. So total outflow= 144000 * 5yrs= 720000

An amount of 630000 (that is 210000 * 3) is recovered in 3 yrs. The balance is recovered in the 4th year

So payback period= 3 yrs + (720000- 630000)/210000= 3 + 0.43= 3.43 yrs

NPV= (210000 * P/A 7% 5yrs) -(144000 * P/A 7% 5yrs)

= 210000 * 4.1 - 144000 * 4.1= 861000 -590400= $270600

answer 2

buying NPV= 255520

leasing NPV= 210767

If we reduce the discount rate to say 2% the NPV of leasing option would be

90000 * 4.713 - 26400 * 4.713 - 50000 = 249747

To fet a higher NPV , we need to take a still lower discount rate say 1%, using present value factors at 1%, we get

NPV= 90000 * 4.853 - 26400 * 4.853 - 50000= 258651

So discount rate= 1%