Part B: Recommendations for the Investment Opportunity

To,

The CEO

XYZ Company

Subject: Recommendations analysis for the Investment Opportunity regarding Make Vs

Buy Decision

Sir,

Below are my main points with regards to recommendations provided by different stakeholders
of the company for the new investment opportunity.

Clear Recommendation:

Based on the results, Stanley’s recommendations are the most beneficial in terms of lowest
nominal and discounted payback periods, highest IRR and annual savings and the greatest NPV
for the 5 years estimated life of the project. In short, we should make this component instead of
buying going with Stanley’s recommended scenario.

Sources & Processes Used and Factors Considered:

The information gathered or the factors considered, include the following:

1. Purchase price of the equipment

2. Useful life of the equipment
3. Net annual working capital required for the investment
4. Estimated annual cost savings from the project
5. Terminal value of the equipment when sold in the end
6. Discount factors to discount the cash flows of the investment opportunity

The processes used for the evaluation of recommendations are the following:

1. Nominal payback period was calculated forming a table for annual cash flows from the
project and using all the above factors or information. The lower the payback period the
better.
2. Discounted payback period was calculated using a separate discount rate factor for each
scenario. Again, the lower the payback period the better.
3. Net Present Value (NPV) was calculated as the sum of all the net cash flows, including
cash inflows and cash outflows from the project. The higher the NPV the better.
4. Internal Rate of Return (IRR) was calculated, which shows the maximum cost of capital
that can be born for the investment, to get a zero NPV. The higher the IRR the better.
Following are the sources used for information and their reasons:

1. Andrew, the colleague from Accounting. Because the make or buy decision involves
management accounting process.
2. Stanley, from sales would surely have experience being a Sales personnel with regards to
financial and non-financial effects of this new equipment over revenues and cash
generation.
3. Eva, from engineering can provide a better insight with regards to technical aspects of the
equipment, like accurate useful life of the project.
4. Paul, the Product Manager can provide reliable information with regards to the benefits
and goodwill value of the inside component production.
5. Olivia, the head of operations would surely have the best knowledge of the company’s
operations and its deficiencies and its operational capacity to operate with the new
equipment.

Strategic Benefits and Risks:

Below are highlights of the main data points, the support my position recommended above.

1. Stanley, being sales personnel can evaluate the cost saving to be caused by new
investment. Therefore, its estimated increase in cost savings for 10% from year 2 to 5
is the plus point above other scenarios.
2. Due to this increase in annual cost savings, it also has the lowest nominal payback
period of 3 years and discounted payback period of 3 years & 7 months.
3. It has the highest Net Present Value (NPV) amongst all the recommended scenarios,
which has estimated 5 years useful life of the project.
4. The internal Rate of Return (IRR) is also the highest amongst all the recommended
scenarios.

Below are the data points, that oppose my recommended scenario of Stanley.

1. The discount rate of 10% recommended is not the lowest of all the proposed
scenarios. It means that it carries some amount of risk.
2. The project life is the same as for other scenarios and less than the 7 years project life
scenario recommended by Paul.
3. This scenario does not have the highest NPV overall, as the scenario of Paul has of
$396,249.

Below are some open / unresolved items regarding the project scenarios.

1. Except Paul & Olivia, who have the exact designations of Product Manager & Head
of Operations respectively, there is no specified designation mentioned for Andrew,
Stanley and Eva.
2. Because the exact roles and experience of Andrew, Stanley and Eva is unknown, so it
is difficult to base our decision at their recommendations.
3. What is the reason for using the discount rates recommended by each scenario?
4. What are the background calculations for estimating the annual cost savings?
 5. What are the exact deficiencies in operations that Olivia is not supporting this new
equipment project?

Most accurate scenario from financial perspective:

The most accurate scenario with regards to financial perspective is the one recommended
by Olivia i.e. not to investment in new equipment due to operational deficiencies and
offering an annual cost saving of 4% of the annual costs of $1,2000,000.

The reason for selecting this scenario is the least amount of assumptions used in its
calculations or derived results. There are just three assumptions used in this scenario.

1. Annual cost saving of 4% by negotiation with the supplier looks realistic.

2. The negotiated discount will last for five years also seems more realistic.
3. Usage of risk-free rate as discount factor is also more appropriate as there is no risk
involved due to no investment.

Non-financial factors for the recommended scenario:

My recommendation for proposed scenario of Stanley is based purely of financial factors

described above. But there are some other non-financial factors that are needed to be
considered, discussed below.

1. When the component will be produced in-house, company will have more control
over its quality and hence past quality issues can be resolved in a better way.
2. It will increase the customer base of the company, as the company will be able to sell
the excess production to outside customers.
3. The new equipment will produce more job opportunities, which will be better for the
local community.
4. The goodwill of the company will increase after the establishment of such in-house
high-tech equipment.
5. Relationships with the suppliers may be affected. This non-financial factor is also
needed to be considered by the company.
6. The company’s operational capacity and required expertise to operate the equipment
are also needed to be considered.

Three financially unattractive assumptions:

Below are the three financial assumptions, that if become true, the project would become
financially unattractive and would be considered a bad investment.

1. Considering a more high-tech will replace the proposed equipment soon, the discount
rate might go above IRR or 24% due to risks involved. Which will give a negative
NPV of the investment and hence a non-profitable investment.
2. Due to the above reason, the cost savings might be much lesser than 20%, which
would again provide a negative NVP for the project.
3. Again, due to the above reason, the equipment might become useless in less than 5
years, which again can make the investment a loss opportunity.
Summary for Recommendations & Key action items:

Mr. CEO! I would like to conclude my committee’s recommendations with regards to the
new equipment investment opportunity by resubmitting our endorsement for the scenario
proposed by Mr. Stanley from sales.

I understand, there are financial assumptions and limitations in going with any of the
scenario, but keeping an optimistic approach, we should consider this investment
opportunity worthwhile and profitable for the company both in terms of related financial
benefits and non-financial benefits that this new opportunity will bring to the company.

And we should start making this component instead of buying.

Thanks.

Yours truly,

ABC

Senior Member Finance

XYZ Company