The CEO of Dynamic Manufacturing was at a conference and talked to a supplier about a new piece of equipment for its production process that she believes will produce ongoing cost savings. As the Operations Manager, your CEO has asked for your perspective on whether or not to purchase the machinery.
After talking to the supplier and meeting with your Engineers and Financial Analysts, you’ve gathered the following pieces of data:
• Cost of Machine: $153,000
• Estimated Annual After Tax Cash Flow Savings: $62,000 (which may or may not grow)
• Estimated machinery life: 3-5 years (after which there will be zero value for the equipment and no further cost savings)
• You seem to recall that Dynamic’s Finance organization recommends either a 10% or a 15%discount rate for all Cost Savings Projects
From your MBA class, you know that you need to understand the project financials to ensure that this investment will be economically attractive to Dynamic Manufacturing’s shareholders.
Calculate the Nominal Payback, the Discounted Payback, the Net Present Value and the IRR for each scenario assuming:
A. Alice (A) recommends using the base assumptions above: 3 year project life, flat annual savings, 10% discount rate.
B. Bill (B) recommends savings that grow each year: 3 year project life, 10% discount rate and a 10% compounded annual savings growth in years 2 & 3. In other words, instead of assuming savings stay flat, assume that they will grow by 10% in year 2, and then grow another 10% over year 3 in year.
C. Carla (C) believes we use a higher Discount Rate because of the risk of this type of project: 3 year project life, flat annual savings, 15% discount rate.
D. Danny (D) is convinced the machine will last longer than 3 years. He recommends using a 5 Year Equipment Life: 5 year project and savings life, flat annual savings, 10% discount rate. In other words, assume that the machine will last 2 more years and deliver 2 more years of savings.
Discussion – in a Word document in paragraph form, respond to the following:
1) Which person’s scenario would you present to management and why? From a strictly financial (numbers) perspective, would you recommend this purchase to management?
2) In your opinion, which person’s scenario is based on the most aggressive assumptions? If you were to select this scenario as the basis for your proposal, how would you justify the more aggressive assumptions?