Question

You are the CEO (Chief Executive Officer) of a large industrial grade Group of Bakeries, the operation has been exceptionally profitable, and the Group now has a considerable amount of cash. The Board of Directors has decided to invest the money in expanding the operation rather than distributing dividends to the shareholders. The Marketing Department has identified a new market segment, of which your Group of Bakeries can get a considerable share. You decide, therefore, to build a new Production Line; you issue an RFP (Request For Proposal) for the implementation of this new Production Line.

Three Contractors submit their Proposals: one Contractor proposes a low-price Line, another proposes a medium priced one, and a third proposes a state-of-the art computer-controlled Line. Their proposals are summarized as follows:

Low Price Option

• Price: $ 1,000,000
• Operation & Maintenance: the anticipated O&M cost is $ 25,000 per year and is expected to increase, due to wear and tear, by a $ 1,000 per year
• Overhaul need : it is expected that every 5 years there will be the need of a major overhaul at a cost of $ 20,000. After each overhaul, the cost of O&M decreases to its original value ($ 25,000/yr) and then increases again at the same rate ($ 1,000/yr). No overhaul is done at the end of useful life.
• Anticipated Yearly Revenues: it is anticipated that the new production line will produce sales revenues in the amount of $ 200,000 per year, and that such revenues will increase by $ 10,000 per year
• Useful Life: the useful life of this production line is expected to be 20 years
• Salvage Value: at the end of its useful life, the line will be sold on the used market for an anticipated price of $ 50,000

Medium Price Option

• Price: $ 2,000,000
• Operation & Maintenance: the anticipated O&M cost is $ 20,000 per year and is expected to increase, due to wear and tear, by a $ 1,500 per year

• Overhaul need: it is expected that after 10 years there will be the need of a major overhaul at a cost of $ 40,000. After the overhaul, the cost of O&M decreases to its original value ($ 20,000/yr) and then increases again at the same rate ($ 1,500/yr). ). No overhaul is done at the end of useful life.
• Anticipated Yearly Revenues: it is anticipated that the new production line will produce sales revenues in the amount of $ 350,000 per year, and that such revenues will increase by $ 6,000 per year
• Useful Life: the useful life of this production line is expected to be 20 years

• Salvage Value: at the end of its useful life, the line will be sold on the used market for an anticipated price of $ 120,000

State-of-the-Art Option

• Price: $ 4,000,000
• Operation & Maintenance: the anticipated O&M cost is $ 30,000 per year and is expected to increase, due to wear and tear, by a $ 2,500 per year
• Overhaul need: this production line will not need any overhaul during its useful life
• Anticipated Yearly Revenues: it is anticipated that the new production line will produce sales revenues in the amount of $ 500,000 per year, and that such revenues will increase by $ 5,000 per year
• Useful Life: the useful life of this production line is expected to be 20 years
• Salvage Value: at the end of its useful life, the line will be sold on the used market for an anticipated price of $ 120,000

Answer the following questions, and show the calculations in support of your answers:

1. If the cost of capital for your Group of Bakeries is 7% what proposal should you choose?
2. If the cost of capital for your Group of Bakeries is 14% what proposal should you choose?
3. What cost of capital would make the Low-Price option economically identical to the Medium-Price Option?
4. What cost of capital would make the Medium-Price option economically identical to the State-of-the-art Option?
5. What cost of capital would make none of the three options economically feasible?

Answer 1

Based on the given data, pls find below workings for all the three alternatives;

Based on the above workings, the answers are as below:

1. If the cost of capital for your Group of Bakeries is 7% what proposal should you choose?

In this case, the NPV of the medium price option is higher than any other option; hence, this is proposed to choose; However, if the company is more interested to have lower Payback period, then Low option Price option is feasible; And if the company has capital constraints as well, then choosing Low Price option shall be feasible as with lower investment (initial outflow), the it gives the higher IRR than any other Project; However, overall considering all the factors, it is feasible to go for the option with higher NPV, i.e., Medium Price Option;

2. If the cost of capital for your Group of Bakeries is 14% what proposal should you choose?

By using Scenario Manager in EXCEL, have computed the NPV, IRR and Payback period using 14% Cost of capital with all other factors remaining unchanged; In this case, Low Price Option to feasible to choose by considering any other factors - NPV and IRR are higher than any other options; And even Payback period is lower than rest of the two options;

3. What cost of capital would make the Low-Price option economically identical to the Medium-Price Option?

For finding such cost of capital between two projects/optinos, we need to find the Cross over rate; This is the rate at which both the options shall deliver the same economic benefits; In this case, at Cost of Capital of 11.39%, both Low Price option and Medium Price option shall have identical economic values;

4. What cost of capital would make the Medium-Price option economically identical to the State-of-the-art Option?

Similarly, at Cost of capital of 1.55%, Medium Price option and State of the Art options shall have identical economic values;

5. What cost of capital would make none of the three options economically feasible?

In this case, the IRRs of all the three options need to be compared; Referring to above workings on three options, the IRRs are 21% for Low option, 17% for Medium option and 11% for State of the Art option; Given this scenario, the Cost of Capital higher than 21% shall make all the three opions economically non-feasible.