Question

The company has been growing steadily over the past 5 years, and the financials and future prospects look good. Your CEO has asked you to run the numbers. After doing some digging into the business, you have gathered information on the following:

• The estimated purchase price for the equipment required to move the operation in-house would be $750,000. Additional net working capital to support production (in the form of cash used in Inventory, AR net of AP) would be needed in the amount of $35,000 per year starting in year 0 and through all years of the project to support production as raw materials will be required in year o and all years to run the new equipment and produce components to replace those purchased from the vendor..

• The current spending on this component (i.e. annual spend pool) is $1,200,000. The estimated cash flow savings of bringing the process in-house is 20% or annual savings of $240,000. This includes the additional labor and overhead costs required.

• Finally, the equipment required is anticipated to have a somewhat short useful life, as a new wave of technology is on the horizon. Therefore, it is anticipated that the equipment will be sold after the end of the project (the last year of generated cash flow) for $50,000. (i.e. the terminal value).

As part of your research, you have sought input from a number of stakeholders. Each has raised important points to consider in your analysis and recommendation. Some of the points and assumptions are purely financial. Others touch on additional concerns and opportunities.

Scenario:

Emma from Engineering believes we use a higher Discount Rate because of the risk of this type of project. As such, she is recommending a 5-year project life and flat annual savings. Emma suggests that even though the equipment is brand new, the updated production process could have a negative impact on other parts of the overall manufacturing costs. She argues that, while it is difficult to quantify the potential negative impacts, to account for the risk, a 12% discount rate should be used. Being an engineer, Emma feels that the stated terminal value is low based on her experience, and is recommending a $75,000 terminal value.

Question:

Using the data presented above (and ignoring the extraneous information), for this profit and supply chain improvement project, calculate each of the following (where applicable):

• Nominal Payback

• Discounted Payback

• Net Present Value

• Internal Rate of Return

Nominal Payback: 3.83

Discounted Payback: 0.00

NPV: (3,463.86)

IRR: 11.8%

Please work out the problems so the calculations match the numbers above.

Answer 1

1. Initian Investment:

Purchase of Equipment = $750000

Working capital at time zero = $35000

Total Investment reuired = $785000

2. Cash Inflows:

Annual Savings in bringing this facility inhouse = $240000

Less: Working capital required per year = (35000)

Net Annual savings = $205000

3. Nominal Payback Period:

4. Discounted payback period:

Annual Savings	Working capital	Terminal Value	Net Inflows	PV factor	Discounted Value	Cumulative Discounted Value
240000	35000	0	205000	0.8929	183044.5	183044.5
240000	35000	0	205000	0.7972	163426	346470.5
240000	35000	0	205000	0.7118	145919	492389.5
240000	35000	0	205000	0.6355	130277.5	622667
240000	35000	75000	280000	0.5674	158872	781539

It can be clearely seen that 781539 is the dicounted Value of Cash inflows.And we have invetment of 785000. So excat discount payback can't be calculated in this case because the invetment has not recovered initslef in project period of 5 years.

5. NPV

Pv of cash inflows - Initial invesment.

Both figures calculated above:

781539-7850000 = - 3461

6. IRR

Two ways to calculated IRR:

a) If you Texas BA 2 calci allowed then

put values as.CF0= -785000, CF1= 205000, F01=4, CF2=280000

then compute IRR= its comes as 11.8%

b) Second method is hit and trial with interpolation.

IRR is the rate where PV of cahs inflows = PV of cash outflows, So NPV at 12% is - 3461 so we need to lower the discount rate to get higher result which make NPV at Zero.

So calculate NPV again at 10% with above given cash flows, Now.

Calculated NPV at 10% is = + 38380

Now Calculate the Interpolation Equation

IRR would be 11.8 %.