Question #2

Stephen Herron, owner of a small manufacturer, Isis Technology (IT), has asked you to provide your opinion on the options available to replace an old machine. Two suppliers have provided price and cost estimates. The supplier of the old machine, Canadian Equipment Inc. (CEI), has improved its equipment but continues with the same specialized design. A new supplier, Alto Design Equipment (ADE), has a new innovative design that can process any one of the products produced by IT.

Stephen is excited about the new design. Its products usually have a short life cycle where sales increase for five years and then decline. IT could use the new design proposed by ADE to process its products that will stabilize output over the next five years. IT’s cost of capital is 11%. After careful analysis of the two designs, he prepares the following forecast of the expected cash flows.

After-tax cash inflows and outflows for CEI and ADE equipment ($000)

a. Stephen believes in the payback period technique. He believes that any project that does not return its cost within three years should not be undertaken. Which machine should IT buy if the payback period technique is used?

b. Stephen’s wife, a business school graduate, likes the NPV method, since she knows that this method explicitly considers the cost of financing associated with the investment, as well as the time at which cash flows occur. Calculate the NPV and Profitability Index (PI) of each project. Which machine should IT buy according to this criterion?

c. Stephen’s neighbor is a business analysis and he considers Internal Rate of Return to be far superior method to analyse projects.  He determines that, for this type of equipment, the rate of return should be at least 17%.  Calculate the IRR for CEI and ADE.

d. Write a memo to Stephen to help him decide which method he should use in making his decision. In your memo, include a table that shows your results for each of the methods, as shown below. Include a short description of your analysis, the results of each method, and your final reasoned recommendation.