NPV Problem and Solution

>> December 16, 2011


Lexington Auto Parts Co. is considering installation of a *CIM system as part of its implementation of a JIT (Just-In-Time) philosophy. Cathie Rupp, company president, is convinced that the new system is necessary, but she needs the numbers to convince the board of directors. This is a major move for the company, and approval at board level is required.


Destiny Rupp, Cathie’s daughter, has been assigned the task of justifying the investment. She is a business school graduate and understands the use of NPV for capital budgeting decisions. To identify relevant costs, she developed the following information.

LA Parts Co. produces a variety of small automobile components and sells them to auto manufacturers. It has a 40% market share, with the following condensed results expected for 2007:

Sales 12,000,000
Cost of goods sold
Variable 4,000,000
Fixed 4,300,000 8,300,000

Selling and administrative expenses

Variable 2,000,000
Fixed 400,000 2,400,000
Operating income 1,300,000

Installation of the CIM system will cost $5,000,000, and the company expects the system to have a useful life of 6 years with no salvage value. Installation will occur at the beginning of 2008. In 2008, the training costs for personnel will exceed any cost savings by $400,000. In years 2009 through 2013, variable cost of goods sold will decrease by 35%, an annual savings of $1,400,000. There will be no savings in fixed cost of goods sold – it will increase by the amount of the straight line depreciation on the new system. Selling and administrative expenses will not be affected. The required rate of return will be 12%. Assume that all cash flows occur at the end of the year, except the initial investment, which occurs at the beginning of 2008.

Required:

(a) Suppose that Destiny Rupp assumes that production and sales would continue for the next 6 years as they are expected in 2007 in the absence of investment in the CIM. Compute the NPV of investing in the CIM.

(b) Now suppose Destiny predicts that it will be difficult to compete without installing the CIM. She has undertaken market research that estimates a drop in market share of 3 percentage points a year starting in 2008 in the absence of investment in the CIM. Her study also showed that the total market sales level will stay the same, and she does not expect market prices to change. Compute the NPV of investing in the CIM.

(c) Prepare a memo from Destiny Rupp to the board of directors of LA Parts Co. In the memo, explain why the analysis in part (b) is appropriate and why analyses such as that in part (a) cause companies to under-invest in high technology projects. Include an explanation of qualitative factors that are not included in the NPV calculation.

*Computer-Integrated Manufacturing systems: Systems that use computer-aided design, computer-aided manufacturing, robots, and computer-controlled machines.

Alya from Malaysia (12/3/2011 1:31:35)



Alya! This is only one project, rule of thumb of accepting on the basis of NPV. If NPV is good and positive, you should accept the project. If NPV is negative, you should reject this project. So, we calculate NPV by taking your rate of return as cut off rate.

 (a) Suppose that Destiny Rupp assumes that production and sales would continue for the next 6 years as they are expected in 2007 in the absence of investment in the CIM. Compute the NPV of investing in the CIM.



Amount in $
Present Value of 1 $ @12% (Discount Factor)

Present Value of Cash Flows
(A) Cash Outflow




Investment in 2008 ( Beginning)
 5000000
 Not applicable

  5000000
Employees' training Cost (End of 2008)

   400000
 0.89286

   357144
Total Present Value of Cash Out Flow



 5357144





 (B) Revenue ( Cash inflow )
Net Profit before Depreciation and After Tax (See working note
2008
2009
2010
2011
2012
2013
1,300,000
2,700,000
2,700,000
2,700,000
2,700,000
2,700,000
0.89286
0.79719
0.71178
0.63552
0.56743
0.50663

1160718
2152413
1921806
1715904
1532061
1367901

Total Present Value of Cash inflows



9850803
Net Present Value (B) - (A)




4493659

Important Note :  In part (b), if market share will down due to absence of this technology, we will calculate same on reduction of sales. total sales X 3/40. If we use this technology, we can receive this as cash inflow which we already show in first part. So, no need to calculate extra NPV. But, it is point which we tell to board of directors. In C part, you should other ways to analyze of a project. We also see company's current budget.

Working Note for Calculation of Net Profit before Depreciation and After Tax







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