Capital Rationing Between Automation and Analytics
You are the finance business partner for a $300 million manufacturer. The capital committee has a $5.0 million discretionary budget for the coming year and two projects that together exceed it. Project A: automated assembly line, initial outlay $4.2 million, pre-tax operating savings $1.25 million per year for seven years, no salvage value. Project B: analytics platform, initial outlay $1.6 million, pre-tax savings $0.55 million per year for seven years. The company’s WACC is 9% and tax rate is 25%. Project A requires a 12-month installation, union consultation, and a volume assumption tied to a customer contract that expires in two years. Project B can be deployed in four months and scaled. The CFO says, 'Use profitability index; B is clearly better.' The COO says A is strategic and wants both, which would require an extra $0.8 million. No other positive-NPV projects are ready. The committee wants a recommendation that balances value creation and execution risk.
1. Calculate after-tax annual cash flows, NPV, and profitability index for each project. Show formulas.
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After-tax cash flow = pre-tax savings × (1 − 25%).
- A: $1.25M × 0.75 = $0.9375M per year.
- B: $0.55M × 0.75 = $0.4125M per year.
Annuity factor at 9% for 7 years = [1 − (1.09)^−7] / 0.09 ≈ 5.033.
- A PV = $0.9375M × 5.033 = $4.718M; NPV = $4.718M − $4.2M = $0.518M; PI = $4.718M / $4.2M = 1.12.
- B PV = $0.4125M × 5.033 = $2.076M; NPV = $2.076M − $1.6M = $0.476M; PI = $2.076M / $1.6M = 1.30.
Both are positive NPV. B has the higher PI; A has the slightly higher absolute NPV and uses more capital.
2. Recommend which project(s) to fund under the $5M constraint and address the CFO/COO disagreement.
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Under a hard $5M cap, A and B together cost $5.8M, so the choice is A alone (NPV $0.518M) versus B alone (NPV $0.476M). The CFO's PI rule favors B, but PI ranks efficiently only when capital is fully deployable and alternative positive-NPV projects exist. Here no other projects are ready, so A creates about $42k more NPV. However, A carries installation, union, and customer-contract risk, and its cash flows start later; B is faster, scalable, and lower-risk.
Recommendation: fund A, conditioned on a signed union agreement and customer-contract extension, because it creates the most value and the risk can be staged. If those conditions cannot be met within 60 days, fund B and return or hold the remaining capital. The COO's 'both' option is justified only if the extra $0.8M costs less than the incremental NPV of B ($0.476M); at a reasonable cost of capital it does, so negotiating the extra $0.8M is the best outcome if execution capacity exists.
3. Identify two sensitivity/risk factors that could change the ranking and how you would test them.
Read the worked answer
First, A's savings are volume-linked: test a 20% savings shortfall and a one-year delay. At $0.75M after-tax savings, A's PV falls to $3.775M and NPV to −$0.425M, so B would clearly win. Second, B's adoption risk: test savings at 70% of plan; B's NPV falls to about −$0.15M (PV $1.453M − $1.6M), which would make A preferable if its contract is secure. Also test WACC at 11%: the annuity factor drops to 4.712, reducing A's NPV to $0.218M and B's to $0.344M-B wins on both NPV and PI. Present a two-way sensitivity table of savings realization versus delay.