Question

The estimated purchase price for the equipment required to move the operation in-house would be $750,000. Additional networking 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).

Overview In this assignment, you will take on the role of a senior member of the finance team assigned to lead the investment committee of a medium-sized telecommunications equipment manufacturer. Your team is evaluating a “make-versus-buy” decision that has the potential to improve the company’s competitiveness, but which requires a significant capital investment in new equipment.

The assignment is organized into two parts: Part A: Data calculations based on the information in the scenarios Part B: Recommendations based on the calculations Opportunity Details The new equipment would allow your company to manufacture a critical component in-house instead of buying it from a supplier. This capability would help you stabilize your supply chain (which has suffered from some irregularities and quality issues in the past). It could also have a positive impact on profitability through the absorption of fixed costs since this new machine will have plenty of excess capacity. There may even be a possibility that the company could leverage this capability to create a new external revenue stream by providing services to other companies. The company has been flourishing 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:

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

1. Andrew, your colleague from Accounting, recommends using the base assumptions above: 5-year project life, flat annual savings, and 10% discount rate. Andrew does not feel the equipment will have any terminal value due to advancements in technology.

2. Stanley from Sales is convinced that this capability would create a new revenue stream that could significantly offset operating expenses. He recommends savings that grow each year: 5-year project life, 10% discount rate, and a 10% annual savings growth in years 2 through 5. In other words, instead of assuming savings stay flat, assume that they will grow by 10%% in year 2, and then grow another 10% over year 2 in year 3, and so on. Stanley feels that the stated terminal value is reasonable and used it in his calculations.

3. Eva 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. Eva 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, Eva feels that the stated terminal value is low based on her experience, and is recommending a $75,000 terminal value,

4. Paul, the Product Manager, is convinced the new capability will allow better control of quality and on-time delivery, and that it will last longer than 5 years. He recommends using a 7 Year Equipment Life (which means a 7-year project and that savings will continue for 7 years), flat annual savings, and 10% discount rate. In other words, assume that the machine will last 2 more years and deliver 2 more years of savings. Paul also feels the equipment will have an estimated terminal value of $25,000 at the end of its 7- year useful life as it will be utilized longer thus having less value at the end of the project and savings.

5. 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 feels 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 IRR metrics are not meaningful. Simply provide the NPV of the Savings cash flows).

Scenario	Nominal Payback	Discounted Payback	Net Present Value	Internal Rate of Return
#1: Andrew
#2: Stanley
#3: Eva
#4: Paul
#5: Olivia	N/A	N/A		N/A

Is requesting to fill in the Input from Stakeholders 1-5 the Nominal
Payback, Discounted Payback, Net Present Value, and Internal Rate of Return. This is where I am lost. The Professor did not like my last data.

Answer 1

Given Information

Purchase Price = $750,000

Additional Investment = $35,000

Total Investment at Year 0 = $785,000

Net Cash Inflows = $240,000 – 35000 = $205,000

Project Life = 5 Years

Terminal Value = $50,000

Projected figures according to Andrew’s Proposal

Investment	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Cash Flows	-785000	205000	205000	205000	205000	205000
PV Factor	1	0.91	0.83	0.75	0.68	0.62
Discounted CF	-785000	186363.6	169421.5	154019.5	140017.8	127288.9
Cumulative CF	-785000	-580000	-375000	-170000	35000	240000
Cumulative DCF	-785000	-598636.4	-429214.9	-275195.3	-135177.6	-7888.712

Nominal Payback = 3 +(35000/205000) = 3.17 Years

Discounted Payback = The project will not break even in 5 Years

NPV = Present Value of Cash Inflows – Cash Outflows

= (186363.6+169421.5+154019.5+140017.8+127288.9)-(785000) = -7888.71

IRR = 9.61 % (using IRR function on excel)

Projected figures according to Stanley’s Proposal

Investment	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Cash Flows	-785000	205000	225500	248050	272855	350140.5
Cumulative CF	-785000	-580000	-354500	-106450	166405	516545.5
PV Factor	1	0.91	0.83	0.75	0.68	0.62
Discounted CF	-785000.0	186363.6	186363.6	186363.6	186363.6	217409.7
Cumulative DCF	-785000.0	-598636.4	-412272.7	-225909.1	-39545.5	177864.2
Discount Rate	10%

Nominal Payback = 3 +(166405/272855) = 3.61 Years

Discounted Payback = 4+(177864.2/217409.7) = 4.81 Years

NPV = Present Value of Cash Inflows – Cash Outflows

= (186363.6+186363.6+186363.6+186363.6+217409.7)-(785000) = 177864.5

IRR = 11 % (using IRR function on excel)

Projected figures according to Eva’s Proposal

Investment	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Cash Flows	-785000	205000	205000	205000	205000	280000
Cumulative CF	-785000	-580000	-375000	-170000	35000	315000
PV Factor	1.00	0.89	0.80	0.71	0.64	0.57
Discounted CF	-785000.0	183035.7	163424.7	145915.0	130281.2	158879.5
Cumulative DCF	-785000.0	-601964.3	-438539.5	-292624.6	-162343.4	-3463.9
Discount Rate	12%

Nominal Payback = 3 +(35000/205000) = 3.17 Years

Discounted Payback = The project will not break even in 5 Years

NPV = Present Value of Cash Inflows – Cash Outflows

= (183035.7+163424.7+145915+130281.2+1558879)-(785000) = -3463.78

IRR = 11.83 % (using IRR function on excel)

Projected figures according to Paul’s Proposal

Investment	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
Cash Flows	-785000	205000	205000	205000	205000	205000	205000	230000
Cumulative CF	-785000	-580000	-375000	-170000	35000	240000	445000	675000
PV Factor	1.00	0.91	0.83	0.75	0.68	0.62	0.56	0.51
Discounted CF	-785000.0	186363.6	169421.5	154019.5	140017.8	127288.9	115717.2	118026.4
Cumulative DCF	-785000.0	-598636.4	-429214.9	-275195.3	-135177.6	-7888.7	107828.4	225854.8
Discount Rate	10%

Nominal Payback = 3 +(35000/205000) = 3.17 Years

Discounted Payback = 5+(107828.4/115717.2) = 5.93 Years

NPV = Present Value of Cash Inflows – Cash Outflows

= (183035.7+169421.5+154019.5+140017.8+127288.9+115717.2+118026.4)-(785000) = 225,854.81

IRR = 18.19 % (using IRR function on excel)

Projected figures according to Olivia’s Proposal

Investment	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Cash Flows		48000	48000	48000	48000	48000
PV Factor		0.93	0.87	0.82	0.76	0.71
Discounted CF		44860	41925	39182	36619	34223
Discount Rate	7%

NPV = Present Value of Cash Inflows

= (44860+41925+39182+36619+34223) = 196,809