Question

You are the employee of Typing4u Enterprise, a typing service company based in Selangor. The company has decided to upgrade its equipment. It currently has a widely used version of a word processing program. The company wishes to invest in more up-to-date software and to improve its printing capabilities.

Two options have emerged. Option 1 is for the company to keep its existing computer system, and upgrade its word processing program. The memory of each individual work station would be enhanced, and a larger, more efficient printer would be used. Better telecommunications equipment would allow for the electronic transmission of some documents as well.

Option 2 would be for the company to invest in an entirely different computer system. The software for this system is extremely impressive, and it comes with individual laser printers. However, the company is not well known, and the software does not connect well with well-known software. The net present value information for these options follows:

Option 1                  Option 2   Initial Investment                         RM(95,000)              RM(240,000) Returns           Year 1                          55,000                         80,000                         Year 2                          30,000                         80,000                         Year 3                          10,000                         80,000                         Net Present Value                 0                                  0

Instruction

(a) Prepare a brief report for management in which you make a recommendation for one system or the other, using the information given.                                                                       (5 Marks)

(b) Management is often faced with the alternative of continuing to make a product or component internally, or going to an external source and purchasing the product or component. In gathering relevant information for these two alternatives, briefly identify the quantitative factors that should be considered. Are there any qualitative factors that should also be considered?            (5 Marks)

[TOTAL 10 MARKS]

Answer 1

Both Options has 0 NPV. It means there will be no profit or no loss on entering into these contracts.

Both Options Payback period is also 3 years.

Option 1 is earning heavy cash inflows initially. But in Option 2, cash flows are equal over the period

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. By contrast, the internal rate of return (IRR) is a calculation used to estimate the profitability of potential investments.

Both of these measurements are primarily used in capital budgeting, the process by which companies determine whether a new investment or expansion opportunity is worthwhile. Given an investment opportunity, a firm needs to decide whether undertaking the investment will generate net economic profits or losses for the company.

NPV and IRR are two discounted cash flow methods used for evaluating investments or capital projects.

NPV is is the dollar amount difference between the present value of discounted cash inflows less outflows over a specific period of time. If a project's NPV is above zero, then it's considered to be financially worthwhile.

IRR estimates the profitability of potential investments using a percentage value rather than a dollar amount.

Qualitative Factors to be considered by management in choosing the alternatives

1. Nature and size of expenditure

2. Lead time requirement

3. Availability of sources

4. Non recurring purchases

5. Size of the expenditure

6. Extent of negotiation.

1. Nature and size of expenditure:

An expenditure of company funds for capital equipment is an ‘investment’. If purchased wisely and operated efficiently, capital equipments generate profits for its owner. Because it exerts a direct influence on the costs of production, the selection of major capital equipment is a matter of significant concern to top management.

Although capital equipment prices cover a wide range, the purchase of most major equipments involves the expenditure of the substantial sum of money. The purchase price for a piece of equipment, however, is frequently over-shadowed in importance by other elements of cost.

Since, a machine is often used for ten years or more, total cost of operation and maintenance during its life time may far exceed its initial cost. Hence, the ultimate (or total life) cost of a machine, relative to its productivity, is the cost factor of primary importance.

Estimating operating and maintenance costs which will be incurred in future years is not easy. Frequently these costs vary from year to year. Consequently, discussions involving the choice among several alternative machines often centre on the probable accuracy of specific cost estimates.

The timing of many capital purchases often presents a paradoxical situation. Typically, the general supply capabilities of capital investment manufacturers do not adjust quickly to changes in levels of demand.

Thus, because capital equipment purchases are made infrequently and can often be postponed, manufacturers of industrial capital goods frequently find themselves in a ‘feast or famine’ type of business. When a purchaser’s business is good, he needs additional production equipment to satisfy his customers burgeoning demands.

But because other purchasers are in the same situation, he also finds capital equipment prices rising in a market of short supply. Conversely, when his business is poor and he does not need additional production equipment, capital equipment is in plentiful supply, often at reduced prices.

2. Lead time requirement:

A unique feature in the purchase of capital equipment is the lead time required for its supply. Though very few types of equipment are standardised, most of the major equipments are custom built and require sufficient lead time for the suppliers to fabricate or manufacture and deliver.

3. Availability of sources:

Since many of the requirements of major equipment are specific and typical for different types of industries, the number of suppliers available is also very few and the organisation has to decide carefully a number of factors.

4. Non recurring purchases:

The purchase of a particular piece of capital equipment typically occurs only once every five to twenty years. For example, one buyer recently purchased a unique high-temperature electric furnace for use in his company’s research and development laboratory.

Since, the furnace is used only periodically for experimental work, it is very likely that another purchase of this kind of equipment will not be made for the next twenty years.

On the other hand, a few industrial operations require the use of many identical machines in the production process. For example, in petroleum and chemical processing plants, the product is transported by pipe line throughout most of the production operation.

This requires dozens, at times hundreds of similar pumps which vary only in size and minor details of construction. To keep capital expenditures at a fairly uniform level from year to year and to minimise maintenance costs, pumps are often replaced on a continuing basis rather than all at once. Although it is relatively uncommon, this type of capital equipment purchase assumes some of the characteristics of conventional production purchasing.

A unique feature of many capital equipment purchases is the lead time requirement. While some types of capital equipments are standard off – the shelf products, most are not. Much production machinery and prime moving equipments are built (at least in part) to operate under specific conditions peculiar to each purchaser’s operation.

Consequently, manufacturing lead time is usually a matter of months or years. The production of a large steam turbine, for example, may require negotiating and expediting work substantially different from that normally required in production purchasing.

5. Size of the expenditure:

This is the major consideration as the organisation would have to invest large amount over a long duration. Moreover, the equipment directly influences the manufacturing operations of the organisation. It is natural that the purchasing of major equipment is a matter of significant concern to the top management.

6. Extent of negotiation:

Purchase of major equipment is a result of careful negotiations and analysis of various alternatives available to an organisation. The number of contacts and discussions with the vendors will be much greater compared to those for the purchase of consumption materials.