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Cost-Benefit Analysis Scenario

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 pollution control equipment manufacturer. Your team is evaluating a “make-versusbuy” 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 positively impact 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 growing steadily over the past 5 years, and the financials and 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 $950,000. 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 $42,000 per year starting in year 0 and through all years of the project to support production as raw materials will be required in year 0 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 $1,800,000. The estimated cash flow savings of bringing the process in-house is 18% or annual savings of $324,000. 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 $60,000. (i.e., the terminal value).

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 of the points and assumptions are purely financial. Others touch on additional concerns and opportunities.

1. Amber, your colleague from Accounting, recommends using the base assumptions above: 5-year project life, flat annual savings, and an 11% discount rate. Amber does not feel the equipment will have any terminal value due to advancements in technology.
2. Brian 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% annual savings growth in years 2 through 5. In other words, instead of assuming savings stay flat, assume that year 2 will be 108% of year 1, year 3 will be 108% of year 2, and so on. Brian feels that the stated terminal value of $60,000 is reasonable and uses it in his calculations.
3. Caleb from Engineering believes we should use a higher Discount Rate because of the risk of this type of project. As such, he is recommending a 5-year project life and flat annual savings. Caleb 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. He argues that, while it is difficult to quantify the potential negative impacts, to account for the risk, a 15% discount rate should be used. As an engineer, Caleb feels that the stated terminal value is low based on her experience and recommends a $75,000 terminal value.
4. Dylan, the Product Manager, is convinced the new capability will allow better quality control 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 a 12% discount rate. In other words, assume that the machine will last 2 more years and deliver 2 more years of savings. Dylan also feels the equipment will have an estimated terminal value of $30,000 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. Eva, 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 he feels confident he can negotiate a discount of 4% off the annual outsourcing cost of $1,800,000 if she lets it be known they are considering taking over this step of the process. As there is little risk associated with Eva’s proposal due to no upfront capital requirements, a lower risk-free discount rate of 6% would be appropriate. Eva feels that any price reductions from the current vendor will last for five years. (NOTE: because there is no “investment,” the Nominal Payback, Discounted Payback, and IRR metrics are not meaningful. Simply provide the NPV of the annual savings cash flows).

Part A: Data Calculations

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

Part B: Recommendations

After completing the calculations for all scenarios, create a brief memo to the CEO outlining your committee’s recommendations. You may organize the memo as you see fit, but it must include the following:

• A clear opening statement of your recommendation for or against the project.
• A brief synopsis of the processes and factors that led to your recommendations.
  • What information did you gather, and how did you get it?
  • From whom did you seek input, and why?
• A summary of the strategic benefits and risks in pursuing (or not pursuing) this project, including:
  • Highlights of the main data points that support your position o Acknowledgment of the data points that oppose your argument
  • Identification of open/unresolved items
• Identification of the scenario that, from a purely financial perspective, represents the most accurate estimate of the anticipated results and your rationale as to why.
• Identification of non-financial elements that need to be considered for the recommended scenario.
• Any assumptions in project economics can have a significant impact on the result. Identify 3 financial elements/assumptions in your analysis that would make this project financially unattractive. Be as transparent and candid as possible. What would have to be true for this to be a bad investment?
• A summary restating your recommendation and key action items.