Engineering Products PLC is considering the purchase of a new CNC milling machine costing ?240,000 and with a four-year life. Management??™s expectations are that the revenue generated by the new machine should cover the initial investment within a period of 3 years and with a 16% return on EBIDTA over investment.
From the assessment using the metrics Payback, ROI, NPV and IRR, it indicates that the project has merits and should be pursued. A sensitivity analysis is also conducted on the two main contributors of cash flow, namely revenue and cost of goods sold.
Case Evaluation Outline
In evaluating the purchase of the CNC milling machine, we will first have to determine the relevant cash flows that is required for the investment. Brealey et al (2008) states some ground rules that will have to be noted. They are:
1. Only Cash Flow is relevant
2. Forgot sunk costs
3. Include all Incidental Effects
4. Include Opportunity Costs
With the above-mentioned in mind, we can now identify the cash flow that are relevant and to calculate the metrics to make the purchase decision. However, because the irrelevant cash flow number lesser than the relevant ones, only the irrelevant ones are listed below to eliminate them from the calculations.
|Cash Flow Type |Reason |
|Other production expenses with overheads equal |Sunk costs – None of the overheads were incurred as a result of the proposal |
|to 20% of labour | |
|Labour Costs & |Sunk costs ??“ will be incurred even if company doesn??™t purchase the new CNC |
|Administration Charge |milling machine |
|Interest on loans |Already factored when using WACC to calculate Payback, IRR and NPV |
There are also other assumptions that we have to factor due to the lack of information so as to complete the picture, we assume:
1. With no market beta provided, debt returns to be at 6% (in line with Government bond rates) and shareholders??™ expected return to be at 16% (in line with the percentage return required on assets)
2. Debt & Equity ratio to be at 40:60. Even though the hurdle rate of 10% seems to be a reasonable estimation, we will need to calculate the Weighted Average Cost of Capital to ensure that the company??™s financing costs is adequately covered.
3. Depreciation to be apportioned using the straight-line method in a 4-year period based on the machine life rather than the accountant??™s assessment of 6-year.
Financial Metrics Employed
There are a few metrics that we can consider for the project but the management has mandated that the project has a Payback period of 3-years. There are certain insufficiencies when using this method singularly to evaluate a project. The first fundamental drawback of using the plain-vanilla Payback method is that the metric ignores the time-value of money. A recommendation will be to use the Discounted Payback method where the time value of money is calculated in the payback period. In the calculations, both the Payback and the Discounted Payback are represented.
Secondly, we are not taking into account any value that will incur in the fourth year of this project. To show a better picture on how the project??™s cash flow and help management decide better, we can also utilize other metrics like NPV, IRR and ROI.
1. NPV takes into account the time value of money over the project period. It is a fairly simple metric to understand, as long as the project has an NPV value equal or greater than 0, it should be considered.
2. IRR, even though it has many drawbacks, will help us to strengthen the case when we are using NPV as an indicator
3. ROI is another metric that is mandated, in which we divide EBIDTA of project over the Cost of Investment to give us the percentage returns from the cash outflow.
Outcome from the metrics
The result as shown in the table below (for details on the calculations, pls see the attached excel file) from our analysis clearly indicates that this project will fulfil the requirements of Payback of 3 years and surpasses the ROI of 16% as set by management. The other two metrics of NPV and IRR are also in favour of the project, with both metrics giving positive returns.
|NPV |180.07 |
|IRR |34% |
|ROI (Based on PV) |64% |
|Payback |3 year |
|Payback based on WACC |3 year |
In all of the metrics listed above, we rely and derive the recommendations based on the business forecasts. And because it is essentially a forecast, there are always possibilities of fluctuations due to market conditions, differences in exchange rates and inflation etc. Thus we need to examine the impact if the cash flow fluctuate. In particular, Revenue and Cost of Goods Sold contribute a significant percentage in the cash flow and so the evaluation will be a +/-10% fluctuation using these two cash flows.
From the calculations based on a fluctuation of 10%, the purchase of the new CNC Machine will not meet the requirement of a 3-year payback if revenue falls below 10% of the forecast. However, the remain metrics still indicate a go-ahead for the purchase.
Other factors for consideration
Although there is a possibility that we will not be able to meet the mandated Payback period should the projected revenue fall 10% below our estimate, the other metrics still advocates a positive decision for the purchase of the new CNC milling machine. There are also other micro and macro views that we should also take into consideration other strategic reasons.
From a micro point of view, the chief engineer has cited that the new machine will improve product quality thus minimizing customer complaints and returns, enabling shorter production runs to increase output and other benefits. With the increased output, the new machine will be able to cover the output of an existing machine. The company can sell off the existing machine for a one-off price and also receive annual cash benefits thereafter.
From a macro perspective, the steel tube division has been a profitable business, operating in an attractive environment with growth potential and has recently been identified as the group??™s core activities. It will be one of the group??™s core revenue generating business in the foreseeable future.
In view of the metrics and strategic considerations, Engineering Products PLC should go ahead with the purchase of the new CNC milling machine. Cash flow may be limited for the fiscal year and funding for this project could mean deferment of other projects but this has to be assessed based on the same Payback, ROI, NPV and IRR metrics to determine which project has better returns for the company.
Brealey, R., Myers, C. and Allen, F. (2008). Principles of Corporate Finance. 9th ed. McGraw-Hill Education (Asia)
ROI based on PV
Payback Years based on WACC