Capital investment decisions
1 The first step is to analyse all relevant operating cash flows and align them with the appropriate alternative. This analysis is as follows:
Moulding Marketing and administrative costs (irrelevant)
*Because the automatic machine produces twice as many units per hour, the direct
manufacturing labour cost with the automatic machine would be £10,000; variable overhead, being 75% of direct manufacturing labour cost, would be £7,500.
Solution Exhibit 13.20 indicates that the automatic machine has a £9,423 net present-value advantage over the moulding machine.
Note: The book value of the old machine is irrelevant and thus is completely ignored. In the light of subsequent events, nobody will deny that the original £50,000 investment could have been avoided, with a little luck or foresight. But nothing can be done to alter the past. The question is whether the company will nevertheless be better off buying the
Net present-value analysis of purchasing new automatic machine.
Sketch of relevant cash flows
End of year 0 1 2 3
4 A. Automatic machine
Net initial investment £(44,000)←−1.000 ←−£(44,000)
Current disposal price
of old equipment 5,000←−−1.000 ←−− £5,000
Recurring operating
cash costs (71,285)←−−2.690 ←−−−−−−−− £(26,500) £(26,500) £(26,500) £(26,500) Present value of net
cash outflows £(110,285) B. Moulding machine
Terminal disposalprice of old equipment
4 years hence £1,342←−−0.516←−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−£2,600
Recurring operating
cash costs (121,050) ←−− 2.690←−−−−−−−− £(45,000) £(45,000) £(45,000) £(45,000) Present value of net
cash outflows £(119,708) Difference in favour of
replacement (A − B) £9,423
An alternative analysis of cash inflows and outflows (in thousands) is:
Total
Sketch of relevant cash flows
End of year 0 1 2 3 4
1 Initial machine investment £(44,000) 2 Current disposal price of
old machine £5,000
Net initial investment £(39,000)←− 1.000←−−− £(39,000)
3 Recurring operating
cash savings 49,765 ←− 2.690←−−−−−−−−−−−−− £18,500 £18,500 £18,500 £18,500 4 Difference in terminal
disposal prices of machines (1,342) ←− 0.516←−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−− (2,600)
Net present value £9,423
machines. The relevant cash flow equals the difference in terminal disposal prices of the two machines. If the toy manufacturer continues to use the old machine, it will receive
£2,600 on disposal of its machine at the end of year 4. If it switches to the new machine, it will receive £0 on disposal at the end of year 4. Hence, by investing in the new machine instead of continuing with the old one, the toy manufacturer forgoes £2,600 in terminal disposal price. Hence, £2,600 appears as a cash outflow in year 4 in the sketch of relevant cash flows.
2 The uniform payback formula can be used because the operating savings are uniform:
Payback period = Net initial investment
Uniform increase in annual cash inflow
£44,000 £5,000
= = 2.1 years
£18,500
P –
The £5,000 current disposal price of the moulding machine is deducted from the
£44,000 cost of the automatic machine to determine the net initial investment in the automatic machine.
3 This is an example of sensitivity analysis:
Note that the net initial investment and the difference in terminal disposal prices of machines are unaffected and hence, are included in the equation at the present values that we calculated earlier. The present value of an annuity of £1 received at the end of each year for 4 years is 2.690.
2.690X = £40,342 X = £14,997
If the annual savings fall by £3,503, from the estimated £18,500 to £14,997, the point of indifference will be reached. (Rounding errors may affect the calculation slightly.)
Because the annual operating savings are equal, an alternative way to get the same answer is to divide the net present value of £9,423 by 2.690 (see Table 4 of Appendix B), obtaining £3,503; £3,503 is the amount of the annual difference in savings that will eliminate the £9,423 of net present value.
(25 min.)
1 The net present-value analysis of the CIM proposal is as follows. We consider the differences in cash flows if the machine is replaced. All values in millions.
Relevant 1 Initial investment in CIM today
2a Current disposal price of old production line 2b Current recovery of working capital (€6 − €2) 3 Recurring operating cash savings
€4* each year for 10 years
4a Higher terminal disposal price of machines (€14 − €0) in year 10
4b Reduced recovery of working capital (€2 − €6) in year 10
Net present value of CIM investment
€(45)
* Recurring operating cash flows are as follows:
Cost of maintaining software programs and CIM equipment €(1.5) Reduction in lease payments due to reduced floor-space requirements 1.0 Fewer product defects and reduced reworking 4.5
Annual recurring operating cash flows €4.0
On the basis of this formal financial analysis, Dinamica should not invest in CIM – it has a negative net present value of €(12.436) million.
2 Requirement 1 only looked at cost savings to justify the investment in CIM. Manuel estimates additional cash revenues net of cash operating costs of €3 million a year as a result of higher quality and faster production resulting from CIM.
From Appendix B, Table 4, the net present value of the €3 million annuity stream for 10 years discounted at 14% is €3 × 5.216 = €15.648. Taking these revenue benefits into account, the net present value of the CIM investment is €3.212 (€15.648 − €12.436) million. On the basis of this financial analysis, Dinamica should invest in CIM.
3 Let the annual cash flow from additional revenues be €X. Then we want the present value of this cash flow stream to overcome the negative NPV of €(12.436) calculated in requirement 1. Hence,
X (5.216) = 12.436
X = €2.384 million
An annuity stream of €2.384 million for 10 years discounted at 14% gives an NPV of €2.384 × 5.216 = 12.436 (rounded).
Relevant 1 Initial investment in CIM today
2a Current disposal price of old production line 2b Current recovery of working capital (€6 − €2) 3a Recurring operating cash savings €4
each year for 5 years
3b Recurring cash flows from additional revenues of
€3 each year for 5 years
4a Higher terminal disposal price of machines (€20 − €4) in year 5
4b Reduced recovery of working capital (€2 − €6) in year 5
Net present value of CIM investment
€(45)
The use of too short a time horizon such as 5 years biases against the adoption of CIM projects. Before finally deciding against CIM in this case, Manuel should consider other factors, including:
a Sensitivity to different estimates of recurring cash savings or revenue gains.
b Accuracy of the costs of implementing and maintaining CIM.
c Benefits of greater flexibility that results from CIM and the opportunity to train workers for the manufacturing environment of the future.
d Potential obsolescence of the CIM equipment. Dinamica should consider how difficult the CIM equipment would be to modify if there is a major change in CIM technology.
e Alternative approaches to achieve the major benefits of CIM such as changes in process or implementation of just-in-time systems.
f Strategic factors. CIM may be the best approach to remain competitive against other low-cost producers in the future.