Question

Input from Stakeholders

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.


1. Ann, your colleague from Accounting, recommends using the base assumptions above: 5-year project life, flat annual savings, and 9% discount rate. Ann does not feel the equipment will have any terminal value due to advancements in technology.

2. Steve 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 an 8% compounded annual savings growth in years 2 through 5. In other words, instead of assuming savings stay flat, assume that they will grow by 8% in year 2, and then grow another 8% over year 2 in year 3, and so on.

3. Ellen 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. Ellen 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 14% discount rate should be used.

4. Peter, 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 savings life), 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. Peter also feels the equipment will have an estimated terminal value of $15,000 at the end of its 7year useful life.

5. Owen, 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. He feels the company should focus on improving communication and supply chain management with its current vendor, and he feels confident he can negotiate a discount of 4% off of the annual outsourcing cost of $875,000 if he lets it be known they are considering taking over this step of the process. As there is little risk associated with Owen’s proposal due to no upfront capital requirements, a lower risk-free discount rate of 7% would be appropriate. Owen 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).

Answer 1

1.

The Net present value ( NPV) is $155,937

The internal rate of return (IRR) is 18.7299%.

The payback period is 3.5 years

The discounted payback period is 4.2 years

2.

The NPV is $255,492

The IRR is 24.9115%.

The payback period is 3.163 years

The discounted payback period is 3.89 years

3.

The NPV is $80,852

The IRR is 19.5295%.

The payback period is 3.5 years

The discounted payback period is 4.52 years

4.

The NPV is $307,894

The IRR is 24.3860%.

The payback period is 3.5 years

The discounted payback period is 4.53 years

5.

The Net present value is $143,507

Explanation:

1.

Prepare the table to compute cumulative cash flows, cumulative discounted cash flows, and NPV and IRR as follows:

The result of the table is as follows:

Hence, the NPV is $155,937 and the IRR is 18.7299%.

Compute the payback period using the equation as shown below:

Payback period = Start year + (Initial cost - Cumulative Cash flow from year 3) / (Cumulative cash flow from year 4 - Cumulative cash flow from year 3)

                      = 3 + ($525,000 - $450,000) / ($600,000 - $450,000)

                     = 3.5 year

Hence, the payback period is 3.5 years.

Compute the discounted payback period using the equation as shown below:

Discounted Payback period = Start year + (Initial cost - Cumulative Discounted Cash flow from year 4) / (Cumulative Discounted cash flow from year 5 - Cumulative Discounted cash flow from year 4)

                      = 4 + ($525,000 - $485,957.98) / ($680,937.40 - $485,957.98)

                     = 4.2 years

Hence, the discounted payback period is 4.2 years.

2.

Prepare the table to compute cumulative cash flows, cumulative discounted cash flows, and NPV and IRR as follows:

The result of the table is as follows:

Hence, the NPV is $255,942 and the IRR is 24.9115%.

Compute the payback period using the equation as shown below:

Payback period = Start year + (Initial cost - Cumulative Cash flow from year 3) / (Cumulative cash flow from year 4 - Cumulative cash flow from year 3)

                      = 3 + ($525,000 - $493,120) / ($688,750 - $493,120)

                     = 3.163 years

Hence, the payback period is 3.163 years.

Compute the discounted payback period using the equation as shown below:

Discounted Payback period = Start year + (Initial cost - Cumulative Discounted Cash flow from year 3) / (Cumulative Discounted cash flow from year 4 - Cumulative Discounted cash flow from year 3)

                      = 3 + ($525,000 - $406,476.33) / ($539,971.04 - $406,476.33)

                     = 3.89 years

Hence, the discounted payback period is 3.89 years.

3.

Prepare the table to compute cumulative cash flows, cumulative discounted cash flows, and NPV and IRR as follows:

The result of the table is as follows:

Hence, the NPV is $80,852 and the IRR is 19.5295%.

Compute the payback period using the equation as shown below:

Payback period = Start year + (Initial cost - Cumulative Cash flow from year 3) / (Cumulative cash flow from year 4 - Cumulative cash flow from year 3)

                      = 3 + ($525,000 - $450,000) / ($600,000 - $450,000)

                     = 3.5 year

Hence, the payback period is 3.5 years.

Compute the discounted payback period using the equation as shown below:

Discounted Payback period = Start year + (Initial cost - Cumulative Discounted Cash flow from year 4) / (Cumulative Discounted cash flow from year 5 - Cumulative Discounted cash flow from year 4)

                      = 4 + ($525,000 - $437,056.85) / ($605,851.66 - $437,056.85)

                     = 4.52 years

Hence, the discounted payback period is 4.52 years.

4.

Prepare the table to compute cumulative cash flows, cumulative discounted cash flows, and NPV and IRR as follows:

The result of the table is as follows:

Hence, the NPV is $307,894 and the IRR is 24.3860%.

Compute the payback period using the equation as shown below:

Payback period = Start year + (Initial cost - Cumulative Cash flow from year 3) / (Cumulative cash flow from year 4 - Cumulative cash flow from year 3)

                      = 3 + ($525,000 - $450,000) / ($600,000 - $450,000)

                     = 3.5 year

Hence, the payback period is 3.5 years.

Compute the discounted payback period using the equation as shown below:

Discounted Payback period = Start year + (Initial cost - Cumulative Discounted Cash flow from year 4) / (Cumulative Discounted cash flow from year 5 - Cumulative Discounted cash flow from year 4)

                      = 4 + ($525,000 - $475,479.82) / ($568,618.02 - $475,479.82)

                     = 4.53 years

Hence, the discounted payback period is 4.53 years.

5.

Compute the NPV of annual savings using the equation as shown below:

Net present value = (Cost * Discount) * PVIFA _{Rate, Period}

                          = ($875,000 * 4%) * PVIFA _{7%, 5}

                          = $35,000 * 4.1002

                          = $143,507

Hence, the NPV is $143,507.