In this assignment, you will take on the role of a senior member of the finance team assigned to lead the
investment committee of a health care equipment manufacturer.
Assignment 2: Cost-Benefit Analysis
Parts A and B Due Sunday, Midnight of Week 10 (25% of Final Grade)
In this assignment, you will take on the role of a senior member of the finance team assigned to lead the investment committee of a health care equipment manufacturer. Your team is evaluating a “make-versus-buy” decision that has the potential to improve the company’s competitiveness, but which requires a significant capital investment in new equipment. The assignment is organized into two parts:
Part A: Data calculations based on the information in the scenarios
Part B: Recommendations based on the calculations
The new equipment would allow your company to manufacture a critical component in-house instead of buying
it from a supplier. This capability would help you stabilize your supply chain (which has suffered from some
irregularities and quality issues in the past). It could also have a positive impact on profitability through the
absorption of fixed costs since this new machine will have plenty of excess capacity.
There may even be a
possibility that the company could leverage this capability to create a new external revenue stream by providing
services to other companies.
The company has been growing steadily over the past 5 years, and the financials and future prospects look
good. Your CEO has asked you to run the numbers. After doing some digging into the business, you have
gathered information on the following:
• The estimated purchase price for the equipment required to move the operation in-house would be
Additional net working capital to support production (in the form of cash used in Inventory,
AR net of AP) would be needed in the amount of $30,000 per year starting in year 0 and through all
years of the project to support production as raw materials will be required in year o and all years to
run the new equipment and produce components to replace those purchased from the vendor.
• The current spending on this component (i.e., annual spend pool) is $1,500,000. The estimated
cash flow savings of bringing the process in-house is 16.67% or annual savings of $250,000. This
includes the additional labor and overhead costs required.
• Finally, the equipment required is anticipated to have a somewhat short useful life, as a new wave of
technology is on the horizon. Therefore, it is anticipated that the equipment will be sold after the end
of the project (the last year of generated cash flow) for $30,000. (i.e. the terminal value).
Input from Stakeholders
As part of your research, you have sought input from a number of stakeholders. Each has raised important
points to consider in your analysis and recommendation. Some of the points and assumptions are purely
financial. Others touch on additional concerns and opportunities.
1. Angela, your colleague from Accounting, recommends using the base assumptions above: 5-year
project life, flat annual savings, and 10% discount rate. Angela does not feel the equipment will
have any terminal value due to advancements in technology.
2. Bob from Sales is convinced that this capability would create a new revenue stream that could
significantly offset operating expenses. He recommends savings that grow each year: 5-year
project life, 10% discount rate, and a 10% annual savings growth in years 2 through 5.
words, instead of assuming savings stay flat, assume that they will grow by 10%% in year 2, and
then grow another 10% over year 2 in year 3, and so on. Bob feels that the stated terminal value of
$30,000 is reasonable and used it in his calculations.
3. Carl from Engineering believes we use a higher Discount Rate because of the risk of this type of
project. As such, she is recommending a 5-year project life and flat annual savings.
Carl suggests that even though the equipment is brand new, the updated production process could have a
negative impact on other parts of the overall manufacturing costs.
He argues that, while it is difficult to quantify the potential negative impacts, to account for the risk, a 15% discount rate should be
used. Being an engineer, Carl feels that the stated terminal value is low based on his experience
and is recommending a $55,000 terminal value.
4. Delilah, the Product Manager, is convinced the new capability will allow better control of quality and
on-time delivery, and that it will last longer than 5 years. He recommends using a 7 Year Equipment
Life (which means a 7-year project and that savings will continue for 7 years), flat annual savings,
and 10% discount rate.
In other words, assume that the machine will last 2 more years and deliver
2 more years of savings. Delilah also feels the equipment will have an estimated terminal value of
$20,000 at the end of its 7- year useful life as it will be utilized longer thus having less value at the
end of the project and savings.
5. Edward, the head of Operations, is concerned that instead of stabilizing the supply chain, it will just
add another process to be managed, and will distract from the core competencies the company
He feels the company should focus on improving communication and supply chain
management with its current vendor, and he feels confident he can negotiate a discount of 3% off
of the annual outsourcing cost of $1,500,000 if he lets it be known they are considering taking over
this step of the process.
As there is little risk associated with Edward’s proposal due to no upfront
capital requirements, a lower risk-free discount rate of 7% would be appropriate. Edward feels that
any price reductions from the current vendor will last for five years. (NOTE: because there is no
“investment”, the Payback and IRR metrics are not meaningful. Simply provide the NPV of the
Savings cash flows).