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Manufacturing company projections: a case-study
MBA, UoPeople
BUS 5110 - Managerial Accounting
Dr. Seval Ozbalci
16/05/2023
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Manufacturing company projections: a case-study
Capital budgeting allows companies to evaluate the viability of their long-term investments
through calculating indicators such as the NPV, IRR, and Payback Period (Heisinger & Hoyle,
n.d.). How are those indicators calculated and interpreted?
Discussion
We take a manufacturing company as a case study. Our aim here is to compare two 7-
years-long purchasing opportunities with different revenues and costs using the indicators. In
addition to the costs and revenues we were provided, we know that labor costs increase by 3%
yearly, that maintenance costs increase by 3% yearly starting from year 6, and that material costs
are larger in the first year but stay constant over the next years. Finally, we are aware that the
required rate of return and the cost of capital are both equal to 8%. To make this comparison, we
will be calculating the NPV, IRR and Payback Period for the two options.
First, we define the concept of the time value of money, which describes how money
received today is more valuable than money received in the future (Heisinger & Hoyle, n.d.). This
is usually because of inflation or uncertainty. To evaluate future cash flows, we need to convert
them to today’s money using the cost of capital. The NPV (Net Present Value) is the sum of future
cash flows of an investment, converted to today’s money using this formula, with 𝐹𝑖 representing
cash flow of year 𝑖 and 𝑟 representing the cost of capital (Heisinger & Hoyle, n.d.).
𝑛
𝐹𝑖
𝑁𝑃𝑉 = ∑
(1 + 𝑟)𝑖
𝑖=0
As for the IRR (Internal Rate of Return), it represents the rate 𝑟 required for an NPV of
zero (Heisinger & Hoyle, n.d.). A company will define a required rate of return, and if the IRR is
𝐹
higher, they would consider the investment. Therefore: 𝐼𝑅𝑅 = 𝑟 such that 𝑁𝑃𝑉 = ∑𝑛𝑖=0 (1+𝑟)
𝑖
𝑖 = 0
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Finally, the payback period can be defined in the time it takes for the investment to cover
its cash outflows (Heisinger & Hoyle, n.d.). The company can set a number of years after which it
aims to recoup its investment. The method doesn’t take into account the time value of money
(TVM) nor does it consider other expenditures after the payback period – say if a product generates
a massive expenditure right after it covered its initial costs (Heisinger & Hoyle, n.d.). It’s simply
the year corresponding to when the cumulative sum of cash flows is greater than zero. Because of
that, we may be underestimating the true period of time that passes before a project is worthwhile
in today’s money – instead we would be evaluating it in non-actualized money.
In addition, we will note the following:
- Net cash flows for a given year are all that year’s expenditures subtracted from that
year’s revenues.
- The Present Value factor (PV factor) gives you the value in today’s dollars of a dollar
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in year n with r being the cost of capital, according to this formula 𝑃 = (1+𝑟)𝑛
- Present cash flows are the product of the PV factor and that year’s net cash flows.
- We estimate the IRR through an Excel formula
Now, for option 1:
Year 0 1 2 3 4 5 6 7
Equipment -75000
Revenues 50000 113000 125000 125000 150000 150000
Maintenance -2500 -2500 -2500 -2500 -2500 -2575 -2652.25
Labor -50000 -51500 -53045 -54636 -56275 -57964 -59703
Materials -20000 -10000 -10000 -10000 -10000 -10000 -10000
Net cash flows -75000 -72500 -14000 47455 57864 56225 79461 77645
PV factor 1.0000 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835
Present cash flows -75000 -67130 -12003 37671 42532 38265 50074 45305
Payback -75000 -147500 -161500 -114045 -56181 43 79505 157150
NPV 59715
IRR 16%
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With an NPV of 59,715$, an IRR of 16% and a payback period of 5, the company could
pursue this option. Indeed, the NPV is greater than zero and the IRR is greater than 8% which was
the required rate of return. What could make us hesitate about this option is the long payback
period of 5 years for an investment of 7 years, which is undesirable (Kagan, 2023). In addition,
since payback period doesn’t take into account the TVM, the true payback period in today’s money
might be higher than 5 years due to future money being less valuable – which means in a 7 years
project, it can be 6 or 7 years which is unacceptable (Kagan, 2023). Another potential issue is that
revenues are estimated to be low at first then increase in the later years, which may be risky
depending on the quality of our projections. Everything we’ve done so far is based on the
projections we were given. They can be inaccurate or the company can go through a market risk
crisis – either a demand slowdown or a raw materials price hike – both of which could damage the
project’s viability (Hertz, 2014). In essence, the company could decide to take this option given
the positive NPV and the IRR greater than the required rate of return, but other qualitative factors
that we lack can say it shouldn’t.
Now for option 2:
Year 0 1 2 3 4 5 6 7
Equipment -50000 10000
Revenues 75000 100000 125000 155000 200000 150000
Maintenance -4500 -4500 -4500 -4500 -4500 -4635 -4774
Labor -70000 -72100 -74263 -76491 -78786 -81149 -83584
Materials -25000 -20000 -20000 -20000 -20000 -20000 -20000
Net cash flows -50000 -99500 -21600 1237 24009 51714 94216 51642
PV factor 1 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835
Present cash flows -50000 -92130 -18519 982 17647 35196 59372 30133
Payback -50000 -149500 -171100 -169863 -145854 -94140 76 51719
NPV -17318
IRR 6%
Option 2 has a negative NPV of -17,318$, an IRR of 6% lower than the required rate of
return, and a payback period of 6 years – one year smaller than the duration of the investment. Due
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to these reasons, we recommend not taking this option. In essence, if the company had to decide,
it should take option 1. But if the company could decide to take no options, then it should.
Conclusion
This challenging case study displays how capital budgeting can be used to differentiate
between two options. The payback period has important limitations that can lead to both options
being invalidated due to not taking into account the time value of money. What we also displayed
was that the tools we had at our disposal are quantitatively good but cannot take into account the
risks that our projections were wrong and cannot quantify qualitative uncertainties. This is why
we recommend the company takes option 1 with a more thorough risk assessment and considering
the time value of money.
References
Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for managers. Accounting for Managers - Table
of Contents. https://2012books.lardbucket.org/books/accounting-for-managers/index.html
Hertz, D. (2014, August 1). Risk analysis in capital investment. Harvard Business Review.
https://hbr.org/1979/09/risk-analysis-in-capital-investment
Kagan, J. (2023, February 26). Payback period explained, with the formula and how to calculate
it. Investopedia. https://www.investopedia.com/terms/p/paybackperiod.asp
