Question

(11-68) Investment in CAD/CAM

Aswega AS is an Estonian manufacturer of electromagnetic flowmeters, heatmeters, and

calibration equipment located in Tallinn. Suppose that it is considering the installation of a

computer-aided design/computer-aided manufacturing (CAD/CAM) system. The current

proposal calls for implementation of only the CAD portion of the system. The manager in

charge of production design and planning has estimated that the CAD portion of

CAD/CAM could do the work of five designers, who are each paid EEK 500,000 per year

(52 weeks×40 hours×EEK 250 per hour), where EEK is the symbol for the Estonian

kroon.

Aswega can purchase the CAD/CAM system for EEK 2.8 million. (It cannot purchase the

CAD portion separately.) The annual out-of-pocket costs of running the CAD portion of

the system are EEK 1.8 million. The company expects to use the system for 8 years. The

company’s minimum desired rate of return is 12%. Ignore income taxed.

(1) Compute the NPV of the investment in the CAD/CAM system. Should Aswega

purchase the system? Explain.

(2) Suppose the manager was not certain about her predictions of saving and economic

life. Possibly the company will replace only four designers, but if everything works out

well, it may replace as many as six. If better systems become available, the company

may use the CAD/CAM system for only 5 years, but it might last so long as 10 years.

Prepare pessimistic, most likely, and optimistic predictions of NPV. Would this analysis

make you more confident or less confident in your decision in number 1? Explain.

(3) What subjective factors might influence your decision?

Answer 1

CALCULATION OF NPV
INITIAL CASH OUTLAY	EEK2.8 MILLION
CALCULATION PRESENT VALUES OF SAVINGS ON INSTALLATION
	(IN MILLIONS)
Particulars	year(1-8)
payment to designers yearly for 5(5*EEK 5,00,000 PER YEAR)	EEK 2.5 MILLION
(-) ANNUAL MAINTENANCE COST FOR CAD	EEK1.8 MILLIONS
NET SAVINGS YEARLY	EEK 0.7 MILLION
NOW BY CALCULATING THE PRESENT VALUE BY PRESENT VALUE ANNUITY FACTOR
NET SAVINGS * PVAF (12%,8 YEARS)
0.7 MILLIONS* 4.96764
3.477347837
EEK 3.48 MILLIONS
NET PRESENT VALUE
PRESENT VALUE OF SAVINGS - INITIAL OUTLAY
EEK 3.48 MILLIONS- EEK 2.8 MILLIONS
EEK 0.68 MILLIONS
AS NPV IS POSITIVE THE PROJECT IS ACCEPTABLE

2)

LETS CONSIDER ALL POSSIBILITIES

INITIAL OUTLAY FOR CAD= EEK 2.8 MILLIONS

LETS ASSUME EACH CONDITION OF CAD WORKING FOR 5 TO 10 YEARS FOR 4 ,5 OR 6 DESIGNERS

						IN MILLIONS
PARTICULARS	YEARS(1-5)	YEARS(1-6)	YEARS(1-7)	YEARS(1-8)	YEARS(1-9)	10 YEARS
ONLY FOUR DESIGNERS(4*EEK 500000PER YEAR)	2	2	2	2	2	2
(-) ANNUAL MAINTENANCE COST OF CAD	1.8	1.8	1.8	1.8	1.8	1.8
NET SAVINGS YEARLY(A)	0.2	0.2	0.2	0.2	0.2	0.2
PVAF FOR RESPECTIVE YEAR(B)	3.6	4.11	4.56	4.97	5.33	5.65
PRESENT VALUE OF SAVINGS(A*B){1}	0.72	0.822	0.912	0.994	1.066	1.13
INITIAL OUTLAY{2}	2.8	2.8	2.8	2.8	2.8	2.8
NPV(1-2)	-2.08	-1.978	-1.888	-1.806	-1.734	-1.67
ONLY FIVE DESIGNERS(5*EEK 500000PER YEAR)	2.5	2.5	2.5	2.5	2.5	2.5
(-) ANNUAL MAINTENANCE COST OF CAD	1.8	1.8	1.8	1.8	1.8	1.8
NET SAVINGS YEARLY(A)	0.7	0.7	0.7	0.7	0.7	0.7
PVAF FOR RESPECTIVE YEAR(B)	3.6	4.11	4.56	4.97	5.33	5.65
PRESENT VALUE OF SAVINGS(A*B){1}	2.52	2.877	3.192	3.479	3.731	3.955
INITIAL OUTLAY{2}	2.8	2.8	2.8	2.8	2.8	2.8
NPV(1-2)	-0.28	0.077	0.392	0.679	0.931	1.155
ONLY SIX DESIGNERS(6*EEK 500000PER YEAR)	3	3	3	3	3	3
(-) ANNUAL MAINTENANCE COST OF CAD	1.8	1.8	1.8	1.8	1.8	1.8
NET SAVINGS YEARLY(A)	1.2	1.2	1.2	1.2	1.2	1.2
PVAF FOR RESPECTIVE YEAR(B)	3.6	4.11	4.56	4.97	5.33	5.65
PRESENT VALUE OF SAVINGS(A*B){1}	4.32	4.932	5.472	5.964	6.396	6.78
INITIAL OUTLAY{2}	2.8	2.8	2.8	2.8	2.8	2.8
NPV(1-2)	1.52	2.132	2.672	3.164	3.596	3.98

SO OUT OF 18 PREDICTIONS ONLY 7 WENT AGAINST OUR DECISION

SO BY CONSIDERING THE PREDICTIONS IT GIVES US MORE CONFIDENCE

THAT DECISION WILL BE CORRECT AS SAID IN ABOVE POINT AND THE SUBJECTIVE FACTORS WHICH MIGHT INFLUENCE OUR DECISION ARE 1) ECONOMIC LIFE OF THE CAD 2) HOW EFFECTIVE WAS CAD SO THAT IT MIGHT REPLACE MORE NUMBER OF DESIGNERS 3) ACTUAL OUT OF POCKET COSTS FOR MAINTAINING THE CAD