Qwest Inc, an Ottawa-based company, enjoys a steady demand for stainless steel infiltrators used in a number of chemical processes. Revenues from the infiltrator division are $50 million a year and production costs are $47.5 million, generating net cash flows of $2.5 million. However, the 10 high precision Rugged stamping machines used in the production process are coming to the end of their useful life. One possibility being considered by the company is simply to replace each existing machine with a new Rugged. These machines will cost $800,000 each and would not involve any additional operating costs. The alternative is to buy 10 centrally controlled HighTech stampers. HighTechs cost $1.25 million each, but unlike the Rugged they would produce a total savings in operating and material costs of $500,000 a year. Moreover, the HighTech is sturdily built and would last 10 years, as against an estimated 7-year life for the Rugged. Analysts in the infiltrator division have produced the summary table shown below, which shows the forecast total cash flows from the infiltrator business over the life of each machine. Qwest’s standard procedures for appraising capital investments involve calculating net present value, internal rate of return, and payback period, and some of these measures are shown in the table. As usual, Melissa Kock arrived early at Qwest’s head office. She had never regretted joining Qwest. Everything about the place, from the narrow windows to the bell fountain in the atrium, suggested a classy outfit. Ms. Kock sighed happily and reached for the envelop at the top of her in-tray. It was an analysis from the infiltrator division of the replacement options for the stamper machines. Pinned to the paper was the summary table of cash flows (shown below) and a note from the Vice President of the company, which read, ‘Melissa, I have read through 20 pages of detailed analysis, and I still don’t know which of the machines we should buy. Looking at the numbers, I suspect the NPV calculation would indicate that the HighTech is best, while the IRR and payback probably suggest the opposite. Would you take a look, then estimate the NPV and payback period, and tell me which one we should buy and why’? You are required to help Ms. Kock by writing a memo to the Vice President. You need to justify your recommendation by (i) constructing a spreadsheet (or using any tools, e.g., formulas, time value of money tables, etc.) to estimate the NPV using a discount rate of 15% and the payback period for the projects, and (ii) explain why some or all of the project analysis techniques listed in the table (i.e., NPV, IRR, Payback period) and their values are inappropriate.
