Dinamica Lda is planning to replace one of its production lines, which has a remaining useful life of 10 years, book value of €9 million, a current disposal value of €5 million, and a neglible terminal disposal value 10 years from now. The average investment in working capital is €6 million.
Dinamica plans to replace the production line with a computer-integrated manufacturing (CIM) system at a cost of €45 million. Manuel Ericeira, the production manager, estimates the following annual cash-flow effects of implementing CIM:
a. Cost of maintaining software programs and CIM equipment, €1.5 million.
b. Reduction in lease payments due to reduced floor-space requirements, €1 million.
c. Fewer product defects and reduced rework, €4.5 million.
In addition, Manuel estimates the average investment in working capital will decrease to €2 million. The estimated disposal value of the CIM equipment is €14 million at the end of 10 years. Dinamica uses a required rate of return of 14%.
Required
1. Calculate the net present value of the CIM proposal. On the basis of this criterion, should Dinamica adopt CIM?
2. Manuel argues that the higher quality and faster production resulting from CIM will also increase Dinamica's revenues. He estimates additional cash revenues net of cash operating costs from CIM of €3 million per year. Calculate the net present value of the CIM proposal under this assumption.
3. Management is uncertain if the cash flows from additional revenues will occur. Calculate the minimum annual cash flow from additional revenues that will cause Dinamica to invest in CIM on the basis of the net present-value criterion.
4. Discuss the effects of reducing the investment horizon for CIM to five years, Dinamica's usual time period for making investment decisions. Assume disposal values at the end of five years of CIM line, €20 million; and of old production line, €4 million. Also assume additional cash revenues net of cash-operating costs from CIM of €3 million per year.