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Chapter 26: Problem 16

The plant manager of O'Brien Equipment Company is considering the purchase of a new robotic assembly plant. The new robotic line will cost \(\$ 1,250,000\). The manager believes that the new investment will result in direct labor savings of \(\$ 250,000\) per year for 10 years. a. What is the payback period on this project? b. What is the net present value, assuming a \(10 \%\) rate of return? c. What else should the manager consider in the analysis?

Short Answer

Expert verified
The payback period is 5 years; NPV is approximately \$534,212. Consider qualitative factors beyond numbers.

Step by step solution

01

Calculate the Payback Period

The payback period is the time it takes for an investment to generate an amount of income or savings equal to the cost of the investment. To find the payback period, divide the initial cost of the investment by the annual savings:\[\text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Savings}} = \frac{1,250,000}{250,000} = 5 \text{ years}\]
02

Determine Cash Flows for NPV Calculation

We need to outline the cash flows for the net present value (NPV) calculation. The initial investment of \(\\(1,250,000\) happens at year 0, and the annual savings of \(\\)250,000\) for 10 years are the cash inflows.
03

Compute Discounted Cash Flows

For each year's cash flow, we calculate the present value using the formula:\[\text{PV} = \frac{\text{Cash Flow at year } n}{(1 + r)^n}\]Where \(r = 0.10\) is the discount rate:\[\text{PV of Years 1 to 10} = \sum_{n=1}^{10} \frac{250,000}{(1 + 0.10)^n}\]Compute this sum for each year.
04

Calculate Total NPV

Sum the present values of all cash inflows from Step 3 and subtract the initial investment to find the NPV:\[\text{NPV} = (\text{PV of Years 1 to 10}) - 1,250,000\]Evaluating this gives \(NPV \approx 534,212\) depending on precise calculations, which means the project adds this value to the firm's wealth.
05

Other Considerations

The manager should also consider qualitative factors such as the impact on labor (e.g., potential job losses), the risk of technological obsolescence, maintenance and operating costs, potential for increased production efficiency, and its alignment with strategic business goals.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Payback Period
The concept of the payback period is a simple method used in capital budgeting. It helps determine how long it will take to recover the initial investment from generated cash flows from the project. Essentially, it tells us when the initial cost is evened out by the cash inflows.
In our example, the plant manager of O'Brien Equipment Company is considering a new robotic assembly plant that costs $1,250,000. The expected yearly savings from this investment is $250,000. The calculation shows the payback period is 5 years, made by dividing the initial investment by the annual savings.
Payback period is important because it gives a quick estimate of risk. The shorter the payback, the less risky the investment. However, it does not account for any benefits that occur after the payback period or the time value of money.
Net Present Value
Net Present Value (NPV) is a more sophisticated investment appraisal technique. It takes into account all cash flows of a project and discounts them to their present value using a specific discount rate. NPV helps assess if an investment will add value to the company.
In the exercise, the cash inflows are $250,000 per year for 10 years, with an initial investment of $1,250,000. Using a 10% discount rate, each cash inflow is adjusted for its present value. After calculating, these are summed up and the initial investment is subtracted to get the NPV. This yielded an estimated NPV of $534,212, indicating the investment is expected to add this amount in value to the company.
NPV considers both the magnitude and timing of cash flows, which makes it a more reliable tool than just looking at the payback period. Generally, a positive NPV suggests a financially promising project.
Investment Analysis
Investment analysis is crucial in decision-making for capital projects. It involves assessing potential investments to ensure they align with a company's strategic objectives and financial metrics. Beyond numerical calculations like payback period and NPV, qualitative factors require consideration.
In our scenario, the manager must also think about the broader impact of the new robotic line on the business and workforce. Key considerations include:
  • Potential job impacts due to automation
  • Risks related to technological changes or obsolescence
  • Ongoing maintenance and operating costs, which can affect long-term financial benefits
  • Potential efficiency gains affecting overall productivity
  • Alignment with long-term business goals and strategy
Investment analysis should weave these quantitative and qualitative factors to provide a more comprehensive view of the project's potential success and risks.

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Most popular questions from this chapter

Carnival Corporation has recently placed into service some of the largest cruise ships in the world. One of these ships, the Carnival Glory, can hold up to 3,000 passengers and cost \(\$ 530\) million to build. Assume the following additional information: \- The average occupancy rate for the new ship is estimated to be \(85 \%\) of capacity. \- There will be 300 cruise days per year. \- The variable expenses per passenger are estimated to be \(\$ 80\) per cruise day. \- The revenue per passenger is expected to be \(\$ 310\) per cruise day. \- The fixed expenses for running the ship, other than depreciation, are estimated to be \(\$ 80,000,000\) per year. \- The ship has a service life of 10 years, with a salvage value of \(\$ 90,000,000\) at the end of 10 years. a. Determine the annual net cash flow from operating the cruise ship. b. Determine the net present value of this investment, assuming a \(12 \%\) minimum rate of return. Use the present value tables provided in the chapter in determining your answer. c. Assume that Carnival Corp. decided to increase its price so that the revenue increased to \(\$ 320\) per passenger per cruise day. Would this allow Carnival Corp. to earn a \(15 \%\) rate of return on the cruise ship investment, assuming no change in any of the other assumptions? Use the present value tables provided in the chapter in determining your answer.

Family Care Products Company is considering an investment in one of two new product lines. The investment required for either product line is \(\$ 600,000\). The net cash flows associated with each product are as follows: \begin{tabular}{crr} Year & Liquid Soap & Cosmetics \\ \hline 1 & \(\$ 120,000\) & \(\$ 165,000\) \\ 2 & 120,000 & 155,000 \\ 3 & 120,000 & 140,000 \\ 4 & 120,000 & 140,000 \\ 5 & 120,000 & 110,000 \\ 6 & 120,000 & 90,000 \\ 7 & 120,000 & 80,000 \\ 8 & 120,000 & 80,000 \\ Total & \(\$ \$ 960,000\) & \(\$ 960,000\) \\ \hline \hline \end{tabular} a. Recommend a product offering to Family Care Products Company, based on the cash payback period for each product line. b. Why is one product line preferred over the other, even though they both have the same total net cash flows through eight periods?

International Fabricators Inc. is considering an investment in equipment that will replace direct labor. The equipment has a cost of \(\$ 85,000\), with a \(\$ 5,000\) residual value and a 10 -year life. The equipment will replace one employee who has an average wage of \(\$ 23,000\) per year. In addition, the equipment will have operating and energy costs of \(\$ 6,000\) per year. Determine the average rate of return on the equipment, giving effect to straight-line depreciation on the investment.

Airwave Communications Inc. is considering an investment in new equipment that will be used to manufacture a PDA (personal data assistant). The PDA is expected to generate additional annual sales of 4,800 units at \(\$ 350\) per unit. The equipment has a cost of \(\$ 910,000\), residual value of \(\$ 50,000\), and a 10 -year life. The equipment can only be used to manufacture the PDA. The cost to manufacture the PDA is shown below. \(\begin{array}{lr}\text { Cost per unit: } & \$ 52.00 \\ \text { Direct labor } & 195.00 \\ \text { Direct materials } & 58.00 \\ \text { Factory overhead (including depreciation) } & \$ 305.00 \\ \text { Total cost per unit }\end{array}\) Determine the average rate of return on the equipment.

Integrated Technologies Inc. is considering the purchase of automated machinery that is expected to have a useful life of four years and no residual value. The average rate of return on the average investment has been computed to be \(25 \%\), and the cash payback period was computed to be \(4.5\) years. Do you see any reason to question the validity of the data presented? Explain.
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