Question

Chester Industries manufactures automobile components for the worldwide market. The company has three large production facilities in Virginia, New Jersey, and California, which have been operating for many years. Lance Nicholson, vice president of production, believes it is time to upgrade operations by implementing computer-integrated manufacturing (CIM) at one of the plants. Lance has asked corporate controller Heidi Rowe to gather information about the costs and benefits of implementing CIM. Rowe has gathered the following data:

Initial equipment cost $6,000,000

Working capital required at start-up $600,000

Salvage value of existing equipment $75,000

Annual operating cost savings $ 840,000

Salvage value of new equipment at end of its useful life $200,000

Working capital released at end of its useful life $ 600,000

Useful life of equipment 10 years

Chester Industries uses a 12% discount rate.

(a) Calculate the net present value of Chester's proposed investment in CIM.

(b) Calculate the internal rate of return on Chester's proposed investment.

(c) Do you recommend that the company proceed with the purchase and implementation of CIM? Why or why not?

(d) Christian Hill, manager of the Virginia plant, has been looking over Rowe's information and believes she has missed some important benefits of implementing CIM. Hill believes that implementing CIM will reduce scrap and rework costs by $150,000 per year. The CIM equipment will take up less floor space in the factory than the old equipment, freeing up 13,000 square feet of space for a planned new research facility. Initial plans called for renting additional space for the new facility each year, at a cost of $20 per square foot. Calculate a revised net present value and internal rate of return using this additional information. Does your recommendation change as a result of this new information? Why or why not?

Answer 1

a) Calculation of Net Present Value of proposed investment

calculate the total initial cost required for the proposed investment and calculate the PV of Expected future cash inflow from the investment.

Present Value of Cash Outflow or Initial Cash Outflow
Initial equipment cost	$6,000,000
Plus: Working capital required at start-up	$600,000
Less: Salvage Value of Existing Equipment (It is deducted from initial cost because if the new equipment purchased the old one is to be sold and the proceeds will be used in purchasing the new equipment)	-$75,000
Total Initial Cost or PV of Cash Outflow	$6,525,000

Annual Cash Inflow = Saving in Annual Operating Cost = $840,000

Calculation of Net Present Value

Year		Cash Flow	PV factor @ 12%	Present Value of Cash Flow
0	Initial Cash Outflow	-$6,525,000	1.000	-$6,525,000
1	Cash Inflow (Annual Saving in Operating Cost)	$840,000	0.893	$750,000
2	$840,000	0.797	$669,643
3	$840,000	0.712	$597,895
4	$840,000	0.636	$533,835
5	$840,000	0.567	$476,639
6	$840,000	0.507	$425,570
7	$840,000	0.452	$379,973
8	$840,000	0.404	$339,262
9	$840,000	0.361	$302,912
10	$840,000	0.322	$270,458
10	Working Capital Released	$600,000	0.322	$193,184
10	Salvage value of new equipment at end of its useful life	$200,000	0.322	$64,395
	Net Present Value	-$1,521,234

b) Internal Rate of Return

Internal Rate of Return is the discounting rate at which Initial Investment is equals to the Present Value of Expected Future Cash Flows. In other words, at IRR Net Present Value is ZERO or PV of Cash Outflow (Initial Investment) = PV of Cash Inflows

Hence, IRR is calculated by trial & error method…

At 6.315% the Initial Investment is equals to PV of Cash Inflow. Hence IRR is 6.315%

To prove this, here is the calculation..

Year		Cash Flow	PV factor @ 6.315%	Present Value of Cash Flow
0	Initial Cash Outflow	-$6,525,000	1.000	-$6,525,000
1	Cash Inflow (Annual Saving in Operating Cost)	$840,000	0.941	$790,105
2	$840,000	0.885	$743,173
3	$840,000	0.832	$699,030
4	$840,000	0.783	$657,508
5	$840,000	0.736	$618,453
6	$840,000	0.693	$581,717
7	$840,000	0.651	$547,164
8	$840,000	0.613	$514,663
9	$840,000	0.576	$484,093
10	$840,000	0.542	$455,338
10	Working Capital Released	$600,000	0.542	$325,241
10	Salvage value of new equipment at end of its useful life	$200,000	0.542	$108,414
	Net Present Value	-$101

In the above calculation NPV is coming -$100 (It is assumed that this will be ZERO if we rounded off the factor)..

c) It is not recommended to company to proceed with the purchase and implement of CIM, since the Net Present Value is negative. It means the future expected cash inflows are less than initial cost. It is not benefitial to the company.

d)

Revised Annual Saving in Operating Cost = 840,000 + Scrap and rework cost saving $150,000 + Saving in rent 13,000*$20

= 840,000 + 150,000 + 260,000

= 1,250,000

Calculation of Revised Net Present Value

Year		Cash Flow	PV factor @ 12%	Present Value of Cash Flow
0	Initial Cash Outflow	-$6,525,000	1.000	-$6,525,000
1	Cash Inflow (Annual Saving in Operating Cost)	$1,250,000	0.893	$1,116,071
2	$1,250,000	0.797	$996,492
3	$1,250,000	0.712	$889,725
4	$1,250,000	0.636	$794,398
5	$1,250,000	0.567	$709,284
6	$1,250,000	0.507	$633,289
7	$1,250,000	0.452	$565,437
8	$1,250,000	0.404	$504,854
9	$1,250,000	0.361	$450,763
10	$1,250,000	0.322	$402,467
10	Working Capital Released	$600,000	0.322	$193,184
10	Salvage value of new equipment at end of its useful life	$200,000	0.322	$64,395
	Net Present Value	$795,357

Since the net present value is positive, the proposed investment should be recommended

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