Case ANALYSIS NO.

5
ALMA PINEDA
ELIZA TOLENTINO
FRETZIE ANN VENDIOLA
JAZLYN PACION
JULIET ALEGRIA
NIKKIE SARANA
HONEY PIS-AN
The Drustic Company is proposing to replace its old welt – making machinery with more modern
equipment. The new equipment costs $10 million and the company expects to sell its old equipment
for $1 million. The attraction of the new machinery is that it is expected to cut manufacturing costs
from their current level of $8 a welt to $4. However, as the following table shows, there is some
uncertainty both about future sales and about the performance of the new machinery.

Pessimistic Expected Optimistic

Sales, millions of welts .4 .5 .7
Manufacturing cost with new machinery, dollars per
6 4 3
welt
Economic life of new machinery, years 7 10 13

a) Conduct a sensitivity analysis of the replacement decision, assuming a discount

rate of 12 percent. Drustic does not pay taxes.
b) Drustic could commission engineering tests to determine the actual
improvement in manufacturing costs generated by the proposed new welt
machines. The study would cost $450,000. Would you advise the company to go
ahead with the study?
Question: A

Conduct a sensitivity analysis of the replacement

decision, assuming a discount rate of 12 percent.
Drustic does not pay taxes.
ANSWERS: A

Pessimistic Expected Optimistic

Economic life of new machinery, years 7 years 10 years 13 years

Sales 400,000 500,000 700,000

Manufacturing cost with new machinery,

$2 $4 $5
dollars per welt

Net savings $800,000 $2,000,000 $3,500,000

Present Value of Ordinary Annuity, 12% 4.56376 5.65022 6.42355

Present Value $3,651,008 $11,300,440 $22,482,425

Net Present Value $5,348,992 $2,300,440 $13,482,425

ANSWERS: A

Pessimistic Expected Optimistic

Economic life of new machinery, years 7 years 10 years 13 years

Sales 400,000 500,000 700,000

Manufacturing cost with new machinery,

$2 $4 $5
dollars per welt

Net savings $800,000 $2,000,000 $3,500,000

Cost of investment $9,000,000 $9,000,000 $9,000,000

Present Value of Ordinary Annuity, 12% 4.56376 5.65022 6.42355

Annual Cash Outflow or cost $1,972,058.128 $1,592,858.331 $1,401,094.41

Excess of cost/savings $1,172,058.128 $407,141.669 $2,098,905.59

Solutions: A $10,000,000 - $1,000,000 = $9,000,000

Pessimistic
Sales, millions of welts .4

Manufacturing cost with new machinery, dollars per welt 6

Economic life of new machinery, years 7

Manufacturing Cost per welt Manufacturing Cost per welt

• $8 - $6 = $2 • $8 - $6 = $2
Net Savings Net Savings
• $2 x 400,000 =$800,000 • 400,000 welts x 2 = $800,000
Present Value Annual cash outflow or cost
• PVOA: 12% on 7 years = 4.56376
•$9,000,000 / 4.56376 = $1,972,058.128
• $800,000 x 4.56376 = $3,651,008
Net Present Value Excess of cost over annual savings
•$3,651,008 - $9,000,000 = $5,348,992 •$800,000 - $1,972,058.128 = -$1,172,058.128
Solutions: A $10,000,000 - $1,000,000 = $9,000,000

Expected
Sales, millions of welts .5

Manufacturing cost with new machinery, dollars per welt 4

Economic life of new machinery, years 10

Manufacturing Cost per welt Manufacturing Cost per welt

• $8 - $4 = $4 • $8 - $4 = $4
Net Savings Net Savings
• $4 x 500,000 =$2,000,000 • 500,000 welts x 4 = $2,000,000
Present Value Annual cash outflow or cost
• PVOA: 12% on 10 years = 5.65022 •$9,000,000 / 5.65022 = $1,592,858.331
• $2,000,000 x 5.65022 = $11,300,440
Net Present Value Excess of savings over annual cost
•$11,300,440 - $9,000,000 = $2,300,440 •2,000,000 - $1,592,858.331 = $407,141.669
Solutions: A $10,000,000 - $1,000,000 = $9,000,000

Optimistic
Sales, millions of welts .7

Manufacturing cost with new machinery, dollars per welt 3

Economic life of new machinery, years 13

Manufacturing Cost per welt Manufacturing Cost per welt

• 8 - $3 = $5 • $8 - $3 = $5
Net Savings Net Savings
• $5 x 700,000 = $3,500,000 • 700,000 welts x 5 = $3,500,000
Present Value Annual cash outflow or cost
• PVOA: 12% on 13 years = 6.42355
•$9,000,000 / 6.42355 = $1,401,094.41
• $3,500,000 x 6.42355 = $22,482,425
Net Present Value Excess of savings over annual cost
•$22,482,425 - $9,000,000 = $13,482,425 •$3,500,000 - $1,401,094.41 = $2,098,905.59
ANSWERS: A

Pessimistic Expected Optimistic

Economic life of new machinery, years 7 years 10 years 13 years

Sales 400,000 500,000 700,000

Manufacturing cost with new machinery,

$2 $4 $5
dollars per welt

Net savings $800,000 $2,000,000 $3,500,000

Present Value of Ordinary Annuity, 12% 4.56376 5.65022 6.42355

Present Value $3,651,008 $11,300,440 $22,482,425

Net Present Value $5,348,992 $2,300,440 $13,482,425

ANSWERS: A

Pessimistic Expected Optimistic

Economic life of new machinery, years 7 years 10 years 13 years

Sales 400,000 500,000 700,000

Manufacturing cost with new machinery,

$2 $4 $5
dollars per welt

Net savings $800,000 $2,000,000 $3,500,000

Cost of investment $9,000,000 $9,000,000 $9,000,000

Present Value of Ordinary Annuity, 12% 4.56376 5.65022 6.42355

Annual Cash Outflow or cost $1,972,058.128 $1,592,858.331 $1,401,094.41

Excess of cost/saving $1,172,058.128 $407,141.669 $2,098,905.59

 ANSWERS: A Sensitivity Analysis

ASSUMPTION  50,000 welts

 Variable cost – $6 per welt
 Fixed cost – $200,000

PESSIMISTIC
If the variable cost is $6 per welt, If the variable cost increases from $6 to $8 per If the variable cost decreases from $8 to $4
and the fixed cost is $200,000, the welt and the fixed cost also increases to from per welt and the fixed cost decreases from
pessimistic profit will be negative. $200,000 to $300,000, the pessimistic profit $200,000 to $150,000, the pessimistic profit
will be negative. will be positive.
Sales 400,000
Sales 400,000 Sales 400,000
-Variable Cost 300,000 -Variable Cost 400,000 -Variable Cost 200,000
CM 100,000 CM 0 CM 200,000
-Fixed cost 200,000 -Fixed cost 300,000 -Fixed cost 150,000
Profit 100,000 Profit 300,000 Profit 50,000
 ANSWERS: A Sensitivity Analysis

ASSUMPTION  50,000 welts

 Variable cost – $4 per welt
 Fixed cost – $200,000

EXPECTED
If the variable cost is $4 per welt, If the variable cost decreases from $4 to $3 If the variable increases from $3 to $6 per
and the fixed cost is $200,000, the per welt and the fixed cost will also decrease welt and the fixed cost increases from
expected profit will be negative. from $200,000 to $150,000, the expected $200,000 to $250,000, the expected profit
profit will be positive. will be negative.

Sales 500,000 Sales 500,000 Sales 500,000

-Variable Cost 200,000 -Variable Cost 150,000 -Variable Cost 300,000
CM 300,000 CM 350,000 CM 200,000
-Fixed cost 200,000 -Fixed cost 150,000 -Fixed cost 250,000
Profit 100,000 Profit 200,000 Profit 50,000
ANSWERS: A Sensitivity Analysis

ASSUMPTION  50,000 welts

 Variable cost – $3 per welt
 Fixed cost – $200,000

OPTIMISTIC
If the variable cost is $3 per welt If the variable cost increases from $3 to If the variable cost increases from $4 to
and the fixed cost is $200,000, $4 and the fixed cost will decrease from $6 per welt and the fixed cost increases
the optimistic profit will be $200,000 to $150,000, the optimistic from $150,000 to $500,000, the
positive. profit will be positive. optimistic profit will be negative.

Sales 700,000 Sales 700,000 Sales 700,000

-Variable Cost 150,000 -Variable Cost 200,000 -Variable Cost 300,000
CM 550,000 CM 500,000 CM 400,000
-Fixed cost 200,000 -Fixed cost 150,000 -Fixed cost 500,000
Profit 350,000 Profit 350,000 Profit 100,000
Question: B

Drustic could commission engineering tests to

determine the actual improvement in manufacturing
costs generated by the proposed new welt machines.
The study would cost $450,000. Would you advise
the company to go ahead with the study?
ANSWERS: b

Pessimistic Expected Optimistic

Economic life of new machinery, years 7 years 10 years 13 years

Sales 400,000 500,000 700,000

Manufacturing cost with new machinery,

$2 $4 $5
dollars per welt

Net savings $800,000 $2,000,000 $3,500,000

Present Value of Ordinary Annuity, 12% 4.56376 5.65022 6.42355

Present Value $3,651,008 $11,300,440 $22,482,425

Net Present Value $5,798,992 $1,850,440 $13,032,425

ANSWERS: b

Pessimistic Expected Optimistic

Economic life of new machinery,
7 years 10 years 13 years
years
Sales 400,000 500,000 700,000

Manufacturing cost with new

$2 $4 $5
machinery, dollars per welt

Net savings $800,000 $2,000,000 $3,500,000

Cost of investment $9,450,000 $9,450,000 $9,450,000

Present Value of Ordinary Annuity,
4.56376 5.65022 6.42355
12%
Annual Cash Outflow or cost $2,070,661.034 $1,672,501.248 $1,471,149.131

Excess of cost/savings $1,270,661.034 $327,498.752 $2,028,850.869

Solutions: b $10,000,000 - $1,000,000 = $9,000,000 + $450,000 = $9,450,000

Pessimistic
Sales, millions of welts .4

Manufacturing cost with new machinery, dollars per welt 6

Economic life of new machinery, years 7

Manufacturing Cost per welt Manufacturing Cost per welt

• $8 - $6 = $2 • $8 - $6 = $2
Net Savings Net Savings
• $2 x 400,000 =$800,000 • 400,000 welts x 2 = $800,000
Present Value Annual cash outflow or cost
• PVOA: 12% on 7 years = 4.56376 •$9,450,000 / 4.56376 = $2,070,661.034
• $800,000 x 4.56376 = $3,651,008
Net Present Value Excess of cost over annual savings
•$3,651,008 - $9,450,000 =$5,798,992 •$800,000 - $2,070,661.034 = $1,270,661.034
Solutions: b $10,000,000 - $1,000,000 = $9,000,000 + $450,000 = $9,450,000

Expected
Sales, millions of welts .5

Manufacturing cost with new machinery, dollars per welt 4

Economic life of new machinery, years 10

Manufacturing Cost per welt Manufacturing Cost per welt

• $8 - $4 = $4 • $8 - $4 = $4
Net Savings Net Savings
• $4 x 500,000 =$2,000,000 • 500,000 welts x 4 = $2,000,000
Present Value Annual cash outflow or cost
• PVOA: 12% on 10 years = 5.65022
• $2,000,000 x 5.65022 = $11,300,440 •$9,450,000 / 5.65022 = $1,672,501.248

Net Present Value Excess of savings over annual cost

•$11,300,440 - $9,450,000 = $1,850,440 •$2,000,000 - $1,672,501.248 = $327,498.752
Solutions: b $10,000,000 - $1,000,000 = $9,000,000 + $450,000 = $9,450,000

Optimistic
Sales, millions of welts .7

Manufacturing cost with new machinery, dollars per welt 3

Economic life of new machinery, years 13

Manufacturing Cost per welt Manufacturing Cost per welt

• 8 - $3 = $5 • $8 - $3 = $5
Net Savings Savings
• $5 x 700,000 = $3,500,000 • 700,000 welts x 5 = $3,500,000
Present Value
Annual cash outflow or cost
• PVOA: 12% on 13 years = 6.42355 •$9,450,000 / 6.42355 = $1,471,149.131
• $3,500,000 x 6.42355 = $22,482,425
Net Present Value Excess of savings over annual cost
•$22,482,425 - $9,450,000 = $13,032,425 •$3,500,000 - $1,471,149.131 = $2,028,850.869
ANSWERS: b

Pessimistic Expected Optimistic

Economic life of new machinery, years 7 years 10 years 13 years

Sales 400,000 500,000 700,000

Manufacturing cost with new machinery,

$2 $4 $5
dollars per welt

Net savings $800,000 $2,000,000 $3,500,000

Present Value of Ordinary Annuity, 12% 4.56376 5.65022 6.42355

Present Value $3,651,008 $11,300,440 $22,482,425

Net Present Value $5,798,992 $1,850,440 $13,032,425

ANSWERS: b

Pessimistic Expected Optimistic

Economic life of new machinery,
7 years 10 years 13 years
years
Sales 400,000 500,000 700,000

Manufacturing cost with new

$2 $4 $5
machinery, dollars per welt

Net savings $800,000 $2,000,000 $3,500,000

Cost of investment $9,450,000 $9,450,000 $9,450,000

Present Value of Ordinary Annuity,
4.56376 5.65022 6.42355
12%
Annual Cash Outflow or cost $2,070,661.034 $1,672,501.248 $1,471,149.131

Excess of cost/savings $1,270,661.034 $327,498.752 $2,028,850.869

coNCLUSION

PESSIMISTIC: The group would advise the company not to go

ahead with the study because it has a negative outcome.

EXPECTED: The group would advise the company to go ahead

with the study because it has a positive outcome.

OPTIMISTIC: The group would advise the company to go ahead

with the study because it has a positive outcome.
CONCLUSION

Do not
Pessimistic
proceed

New welt –
Expected Proceed
making to buy
machinery

Proceed
Optimistic to buy