Question

A car manufacturer has been experiencing financial difficulties over the past few years. Sales have reduced significantly as a result of a worldwide economic recession. Costs have increased due to quality issues that led to a recall of some models of its cars.

Production volume last year was 50,000 cars and it is expected that this will increase by 4% per annum each year for the next five years.

The company directors are concerned to improve profitability and are considering two potential investment projects.

Project 1 – implement a new quality control process

The company has paid a consultant process engineer $50,000 to review the company’s quality processes. The consultant recommended that the company implement a new quality control process. The new process will require a machine costing $20,000,000. The machine is expected to have a useful life of five years and no residual value.

It is estimated that raw material costs will be reduced by $62 per car and that both internal and external failure costs from quality failures will be reduced by 80%.

Estimated internal and external failure costs per year without the new process, based on last year’s production volume of 50,000 cars, and their associated probabilities are shown below:

                                    Internal Failure Costs                        External Failure Costs           

                                          $            Probability                           $          Probability

                                    300,000                       50%                             1,300,000        60%

                                    500,000                       30%                             1,900,000        30%

                                    700,000                       20%                             3,000,000        10%

Internal and external failure costs are expected to increase each year in line with the number of car produced.

The company’s accountant has calculated that this investment will result in a net present value (NPV) of $1,338,000 and an internal rate of return of 10.5%.

Project 2 – in-house component manufacturing

The company could invest in new machinery to enable in-house manufacturing of a component that is currently made by outside suppliers. The new machinery is expected to cost $15,000,000 and have a useful life of five years and no residual value. Additional working capital of $1,000,000 will be required as a result of producing the component in-house.

The price paid to the current supplier is $370 per component. It is estimated that the in-house variable cost of production will be $260 per component. Each car requires one component. Fixed production costs, including machinery depreciation, are estimated to increase by $5,000,000 per annum as a result of manufacturing the component in-house.

Depreciation is calculated on a straight line basis.

Additional information

The company is unable to raise enough capital to carry out both projects. The company will therefore have to choose between the two alternatives.

Taxation and inflation should be ignored.

The company uses a cost of capital of 8% per annum.

Requirements

1. Calculate for Project 1 the relevant cash flows that the accountant should have used for year 1 when appraising the project.

2. Calculate for Project 2:

1. The net present value (NPV)
2. The internal rate of return (IRR)

3. Advise the company directors which of the two investment projects should be undertaken

4. A company is considering two alternative investment projects both of which have a positive net present value. The projects have been ranked on the basis of both net present value (NPV) and internal rate of return (IRR). The result of the ranking is shown below:

         Project A                               Project B

                                                NPV                1st                               2nd

                                                IRR                  2nd                              1st

           

Discuss potential reasons why the conflict between the NPV and IRR ranking may have arisen.                    

Answer 1

Project 1
1.Relevant cash flows that the accountant should have used for year 1 when appraising the project.
Savings in Raw material costs	50000*1.04*62=	3224000
Savings in internal failure costs (Sum of Probabilities/50000*(50000*1.04)*80%	(((300000*50%)+(500000*30%)+(700000*20%))/50000*(50000*1.04))*80%=	366080
Savings in external failure costs(Sum of Probabilities/50000*(50000*1.04)*80%	(((1300000*60%)+(1900000*30%)+(3000000*10%))/50000*(50000*1.04))*80%=	1372800
Total relevant cash inflow(Savings)		4962880

Project 2 – in-house component manufacturing
Year	0	1	2	3	4	5
1.Initial cost of machinery	-15000000
2.Additional wkg. Capital(introduced & recovered)	-1000000					1000000
a.No.of cars to be produced		52000	54080	56243	58493	60833
3.Total Savings in variable costs at the rate of (370-260)=110 /car-------(a*$ 110)		5720000	5948800	6186752	6434222	6691591
4. Increase in fixed production costs (leaving out depreciation( $ 15000000/5 yrs.) ,as tax is to be ignored)ie.(5000000-3000000)=2000000		-2000000	-2000000	-2000000	-2000000	-2000000
5.Net annual cash flows(1+2+3+4)	-16000000	3720000	3948800	4186752	4434222	5691591
6. PV F at 8% (1/(1.08)^n	1	0.92593	0.85734	0.79383	0.73503	0.68058
7. PV at 8% (5*6)	-16000000	3444444	3385460	3323579	3259286	3873601
8.NPV (Sum of Row 7)	1286369.48
9. IRR (of row 5)	10.81%

Summary	NPV	IRR
Project 1	1338000	10.50%
Project 2	1286369	10.81%
c. The company should choose Project 1 as its NPV is greater than that for Project 2

d.Potential reasons why the conflict between the NPV and IRR ranking may have arisen:

Both NPV & IRR depend on the cash flows & their occurrence over

1.different time-periods &

2.of different magnitudes

The more the difference in timing (ie. Year of occurrence) & quantum of cash flow (both inflow & outflow), the more will be the conflict between the rankings as per NPV/IRR

Project 1 – implement a new quality control process
Year	0	1	2	3	4	5
Production volume		52000	54080	56243	58493	60833
1.Cost of machine	-20000000
2.Savings in raw material costs at $ 62/ car		3224000	3352960	3487078	3626562	3771624
3.Savings in Internal failure costs(440000/50000*no.of cars*80%)		366080	380723	395952	411790	428262
4.Savings in External failure costs(1650000/50000*no.of cars*80%)		1372800	1427712	1484820	1544213	1605982
5.Net annual cash flows (CF0….CF5)(1+2+3+4)	-20000000	4962880	5161395	5367851	5582565	5805868
6.IRR (of Row CFs (0-5) in 5)	10.43%
NPV calculations
7.PV at 8% COC(1/1.08^n)	1	0.92593	0.85734	0.79383	0.73503	0.68058
8.PV at 8%(CF0…CF5)*PVF (5*7)	-20000000	4595259	4425064	4261173	4103352	3951376
NPV (Sum of PVs in Row 8)	1336225
Workings for probable internal & external failure costs for production volume of 50,000 cars
Probable costs
Internal failure costs
(300000*50%)+(500000*30%)+(700000*20%)=	440000
External failure costs
(1300000*60%)+(1900000*30%)+(3000000*10%)=	1650000
Project 1
As per the accountant	1338000	10.50%
As per above calculations	1336225	10.43%
Minor differences in results for Project 1
But , still Project 1 scores over project 2 as its NPV is higher.