Cost Benefit Analysis
You will take on the role of a senior member of the finance team assigned to lead the investment committee of a medium-sized telecommunications equipment manufacturer. Your team is evaluating a “make-versus-buy” 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 have a positive impact on 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 allow 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 future 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 $500,000. 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 $25,000 per year starting in year 0 and through all 5 years of the project to support production.
- The current spending on this component (i.e. annual spend pool) is $875,000. The estimated cash flow savings of bringing the process in-house is 20% or annual savings of $175,000. This includes the additional labor and overhead costs required.
- Your company has access to a credit line and could borrow the funds at a rate of 6%.
- 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 five years for $25,000. (i.e. the terminal value).
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 10% 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 allow new revenue stream that could significantly offset operating expenses. He recommends savings that grow each year: 5-year project life, 10% discount rate, and a 10% compounded annual savings growth in years 2 through 5. 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 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, 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 7-year 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 5% 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. (NOTE: because there is no “investment”, the Payback and IRR metrics are not meaningful…simply provide the NPV of the 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):
o Nominal Payback
o Discounted Payback
o Net Present Value
o Internal Rate of Return
Present your calculations and results either in an Excel Spreadsheet or in Word (using tables and headers to organize the information in a way that is clear and easy to read). Be sure to show your detailed calculations.
Part B: Recommendations
After completing the calculations for all scenarios, write 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:
o A clear opening statement of your recommendation for or against the project.
o A brief synopsis of the processes and factors that led to your recommendations.
o What information did you gather, and how did you get it?
o From whom did you seek input, and why?
o A summary of the strategic benefits and risks in pursuing (or not pursuing) this project, including:
o Highlights of the main data points that support your position
o Acknowledgement of the data points that oppose your argument
o Identification of open/unresolved items
o An 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.
o An identification of non-financial elements that need to be considered for the recommended scenario.
o 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 with your BOD as possible. What would have to be true for this to be a bad investment?
o A summary restating your recommendation and key action items.
o Submission Requirements
o Focus on the rationale for your recommendations. Include key numbers to support your recommendations, but do no re-present all your calculations.