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.

Question:

Olivia, the head of Operations, is concerned that instead of stabilizing the supply chain, it will just add another process to be managed, and will distract from the core competencies the company currently has. She f eels the company should focus on improving communication and supply chain management with its current vendor, and she feels confident he can negotiate a discount of 4% off of the annual outsourcing cost of $1,200,000 if she lets it be known they are considering taking over this step of the process. As there is little risk associated with Olivia’s proposal due to no upfront capital requirements, a lower risk-free discount rate of 7% would be appropriate. Oliva feels that any price reductions from the current vendor will last for five years. (NOTE: because there is no “investment”, the Payback and IRRmetricsarenotmeaningful. SimplyprovidetheNPVoftheSavingscashflows).

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

Given,

Current outsourcing cost per year= $1,200,000 and expected reduction= 4%

Therefore, Amount of cost savings per year= 1200000*4% = $48,000

Also given,

Period of price reduction= 5 years

Discount rate= 7%

Net Present value of cost savings = 48000*(PVIFA 7%, 5)

=48000* 4.100197 = $196,809.48

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: Savings forgone as reduction in vendor price = (48000)

Less: Working capital required per year = (35000)

Net Annual savings = $157000

Annual Savings	Savings foregone	Working capital	Terminal Value	Net Inflows	Cumulative Net Cash Flows	PV factor	Discounted Value	Cumulative Discounted Value
240000	48000	35000	0	157000	157000	0.9346	146732.2	146732.2
240000	48000	35000	0	157000	314000	0.8734	137123.8	283856
240000	48000	35000	0	157000	471000	0.8163	128159.1	412015.1
240000	48000	35000	0	157000	628000	0.7629	119775.3	531790.4
240000	48000	35000	50000	207000	835000	0.713	147591	679381.4

3. Nominal Payback Period:

As we can see froma above table, Column- Cumulative Net cash flows tells 628000 recovered in 4 years, and to complete 785000 some part of 5th year will be included. So

4. Discounted payback period:

As per the table above, See column Cumultaive discounted values where total of that is 679381.4. that mean investment will be not be recovered with discounted payback period. So discounted payback period would not be calculated.

5. NPV

Pv of cash inflows - Initial invesment.

Both figures calculated above:

679381-7850000 = - 105619

6. IRR

Two ways to calculated IRR:

a) If you Texas BA 2 calci allowed then

put values as.CF0= -785000, CF1= 157000, F01=4, CF2=207000

then compute IRR= its comes as 2.012%

b) Second method is hit and trial with interpolation.

IRR is the rate where PV of cash inflows = PV of cash outflows, So NPV at 7% is - 105619 so we need to lower the discount rate to get higher result which make NPV at Zero.

So calculate NPV again at 2% with above given cash flows, Now.

Calculated NPV at 2% is = + 300

Now Calculate the Interpolation Equation

IRR would be 2.012 %.