Textbook Problem

“I know that it’s the thing to do,” insisted Pamela Kincaid, vice president of finance for Colgate Manufacturing. “If we are going to be competitive, we need to build this completely automated plant.”

 “I’m not so sure,” replied Bill Thomas, CEO of Colgate. “The savings from labor reductions and increased productivity are only $4 million per year. The price tag for this factory—and it’s a small one—is $45 million. That gives a payback period of more than 11 years. That’s a long time to put the company’s money at risk.”

“Yeah, but you’re overlooking the savings that we’ll get from the increase in quality,” interjected John Simpson, production manager. “With this system, we can decrease our waste and our rework time significantly. Those savings are worth another million dollars per year.”

“Another million will only cut the payback to about 9 years,” retorted Bill. “Ron, you’re the marketing manager—do you have any insights?”

“Well, there are other factors to consider, such as service quality and market share. I think that increasing our product quality and improving our delivery service will make us a lot more competitive. I know for a fact that two of our competitors have decided against automation. That’ll give us a shot at their customers, provided our product is of higher quality and we can deliver it faster. I estimate that it’ll increase our net cash benefits by another $2.4 million.”

“Wow! Now that’s impressive,” Bill exclaimed, nearly convinced. “The payback is now getting down to a reasonable level.”

“I agree,” said Pamela, “but we do need to be sure that it’s a sound investment. I know that estimates for construction of the facility have gone as high as $48 million. I also know that the expected residual value, after the 20 years of service we expect to get, is $5 million. I think I had better see if this project can cover our 14% cost of capital.”

“Now wait a minute, Pamela,” Bill demanded. “You know that I usually insist on a 20% rate of return, especially for a project of this magnitude.”

Required:

1. 1. Compute the NPV of the project by using the original savings and investment figures. Calculate by using discount rates of 14% and 20%. Include salvage value in the computation.
2. 2. Compute the NPV of the project using the additional benefits noted by the production and marketing managers. Also, use the original cost estimate of $45 million. Again, calculate for both possible discount rates.
3. 3. Compute the NPV of the project using all estimates of cash flows, including the possible initial outlay of $48 million. Calculate by using discount rates of 14% and 20%.
4. 4. CONCEPTUAL CONNECTION If you were making the decision, what would you do? Explain.