Flowton Products enjoys a steady demand for stainless steel infiltrators used in a number of chemical processes. Revenues from the infiltrator division are $50 million a year, and production costs are $47.5 million. However, the 10 high-precision Munster stamping machines that are used in the production process are coming to the end of their useful life. One possibility is simply to replace each existing machine with a new Munster. These machines would cost $800,000 each and would not involve any additional operating costs. The alternative is to buy 10 centrally controlled Skilboro stampers. Skilboros cost $1.25 million each, but compared with the Munster, they would produce a total saving in operator and material costs of $500,000 a year. Moreover, the Skilboro is sturdily built and would last 10 years, compared with an estimated 7-year life for the Munster. Analysts in the infiltrator division have produced the accompanying summary table, which shows the forecast total cash flows from the infiltrator business over the life of each machine. Flowton’s standard procedures for appraising capital investments involve calculating net present value, internal rate of return, and payback, and these measures are also shown in the table. As usual, Emily Balsam arrived early at Flowton’s head office. She had never regretted joining Flowton. Everything about the place, from the mirror windows to the bell fountain in the atrium, suggested a classy outfit. Ms. Balsam sighed happily and reached for the envelope at the top of her in-tray. It was an analysis from the infiltrator division of the replacement options for the stamper machines. Pinned to the paper was the summary table of cash flows and a note from the CFO, which read, “Emily, I have read through 20 pages of excruciating detail and I still don’t know which of these machines we should buy. The NPV calculation seems to indicate that the Skilboro is better, while IRR and payback suggest the opposite. Would you take a look and tell me what we should do and why. You also might check that the calculations are OK.” Can you help Ms. Balsam by writing a memo to the CFO? You need to justify your solution and also to explain why some or all of the measures in the summary table are inappropriate.
Flowton Products enjoys a steady demand for stainless steel infiltrators used in a number of chemical processes. Revenues from the infiltrator division are $50 million a year, and production costs are $47.5 million. However, the 10 high-precision Munster stamping machines that are used in the production process are coming to the end of their useful life. One possibility is simply to replace each existing machine with a new Munster. These machines would cost $800,000 each and would not involve any additional operating costs. The alternative is to buy 10 centrally controlled Skilboro stampers. Skilboros cost $1.25 million each, but compared with the Munster, they would produce a total saving in operator and material costs of $500,000 a year. Moreover, the Skilboro is sturdily built and would last 10 years, compared with an estimated 7-year life for the Munster.
Analysts in the infiltrator division have produced the accompanying summary table, which shows the
As usual, Emily Balsam arrived early at Flowton’s head office. She had never regretted joining Flowton. Everything about the place, from the mirror windows to the bell fountain in the atrium, suggested a classy outfit. Ms. Balsam sighed happily and reached for the envelope at the top of her in-tray. It was an analysis from the infiltrator division of the replacement options for the stamper machines. Pinned to the paper was the summary table of cash flows and a note from the CFO, which read, “Emily, I have read through 20 pages of excruciating detail and I still don’t know which of these machines we should buy. The NPV calculation seems to indicate that the Skilboro is better, while IRR and payback suggest the opposite. Would you take a look and tell me what we should do and why. You also might check that the calculations are OK.”
Can you help Ms. Balsam by writing a memo to the CFO? You need to justify your solution and also to explain why some or all of the measures in the summary table are inappropriate.
|
Cash Flows (millions of dollars) |
|||||
|
Year: |
0 |
1–7 |
8 |
9 |
10 |
|
Munster |
|||||
|
Investment |
–8.0 |
||||
|
Revenues |
50.0 |
0 |
0 |
0 |
|
|
Costs |
47.5 |
0 |
0 |
0 |
|
|
Net cash flow |
–8.0 |
2.5 |
0 |
0 |
0 |
|
NPV at 15% |
$2.40 million |
||||
|
IRR |
24.5% |
||||
|
Payback period |
3.2 years |
||||
|
Skilboro |
|||||
|
Investment |
–12.5 |
||||
|
Revenues |
50.0 |
50.0 |
50.0 |
50.0 |
|
|
Costs |
47.0 |
47.0 |
47.0 |
47.0 |
|
|
Net cash flow |
–12.5 |
3.0 |
3.0 |
3.0 |
3.0 |
|
NPV at 15% |
$2.56 million |
||||
|
IRR |
20.2% |
||||
|
Payback period |
4.2 years |
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- Which one of the projects should Ms. Balsam recommend to the CFO based on your results in section (a). You need to justify your recommendation and also to explain why some or all of the measures (i.e., NPV,
IRR & Payback) are inappropriate.
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