the CIM project and is concerned that this analysis is shortsighted. He sees many benefits of CIM that have ... Deprecia
Magruder Industries – NPV and Risk Magruder Industries manufactures automobile components that are sold worldwide. The company has three large production facilities and has been debating the benefits of implementing computer-integrated manufacturing (CIM) in one of these factories. A net present value analysis of this investment has been prepared, and summarized results of the analysis are shown on the next page. Ray Cooper, vice-president of production, is heading the committee charged with investigating the CIM project and is concerned that this analysis is shortsighted. He sees many benefits of CIM that have not been included in the analysis. He also believes that the company should view this project as a change in long-range strategy rather than just another investment project. After discussions with the vice-president of marketing, Cooper and Liz Austin, corporate controller, have compiled the following list of benefits with suggestions as to how they might be quantified. •
Increased manufacturing flexibility. The equipment can be easily programmed for process and design changes and from one product line to another. Conceptually, it is as efficient to make one unit of product as to make a large quantity. This provides for more reliable and flexible production scheduling, reduced set-up costs, and reductions in the amounts of required work-in-process and finished goods inventories. Cooper and Austin believe that the projected operational savings should be increased ten percent to include these efficiencies.
•
Improved product quality. CIM reduces the risk of production by making output more uniform and decreasing rework and scrap. In addition, processes can be more easily refined to improve quality. Historically, scrap and rework costs have averaged $150,000 annually. Cooper and Austin believe that by the beginning of Year 3, these costs will average only $50,000.
•
Less required floor space. As computer-controlled equipment replaces conventional equipment and the need for inventory storage is reduced, 3,000 square feet of floor space will be available for other uses. The current plan envisions using this floor space with a current annual cost of $14 per square foot, for new research facilities, precluding the need for additional rental cost. However, this benefit has not been included in the net present value analysis.
•
Increased customer satisfaction. Increased flexibility provides incentive for product improvements and new product development and provides the company with the capability to respond more quickly to customer demands. In addition, improved product quality and turnround times will increase customer acceptance of Magruder's products. While these benefits may not be realized initially, Cooper and Austin believe that revenues will increase as a result of these factors. Therefore, they have suggested that the analysis be revised to include a conservative estimate of $800,000 in additional annual contribution beginning in Year 6.
Cooper and Austin believe that there are significant risks of not purchasing the equipment. For example, Magruder could lose market share if the competition automates and reaps the benefits. However, they have not factored this into the revised net present value analysis. Magruder uses a 12 percent discount rate (present value tables below) and has a 40 percent effective tax rate. For the purpose of analysis, all tax effects and cash flows from equipment acquisition and disposal are considered to occur at the time of the transaction while those from operations are considered to occur at the end of each year.
Magruder Industries – NPV and Risk
Period 1 2 3 4 5 6 7 8 9 10
Present Value of $1.00 0.89 0.80 0.71 0.64 0.57 0.51 0.45 0.40 0.36 0.32
Present Value of an Annuity of $1.00 0.89 1.69 2.40 3.04 3.61 4.11 4.56 4.97 5.33 5.65
Year(s) Affected
Annual Cash Flow Amount
CIM investment
Current
$(6,000,000)
$(6,000,000)
Working capital Gain on equipment disposal (net of tax)
Current
(600,000)
(600,000)
Current
20,000
20,000
1 - 10
600,000
3,390,000
1 - 10
240,000
1,356,000
Salvage (net of tax)
10
200,000
64,000
Recovery of working capital
10
600,000
Operational savings (net of tax) Depreciation tax shield
Net present value of project
Present Value of Cash Flows
192,000 $(1,578,000)
Required: A. Determine whether Magruder Industries should implement computer-integrated manufacturing in one of its factories by preparing a revised net present value analysis. Be sure to support your conclusion with appropriate calculations. B. As Ray Cooper and Liz Austin believe there are risks associated with a decision not to invest in computer-integrated manufacturing, identify at least three ways Magruder Industries could incorporate the risk of not upgrading the manufacturing technology in its net present value analysis.
