Kestrel Cycles: Replacing the CNC Tube Cutter
Kestrel Cycles makes steel frames. Its only CNC tube cutter is nine years old, breaks down monthly and cannot handle the new aluminium range. A replacement costs $600,000, payable immediately, and would be depreciated straight-line to zero over five years. Expected net cash inflows are $180,000, $220,000, $200,000, $160,000 and $120,000. Kestrel's cost of capital is 10%. The finance director uses payback (maximum 3 years) and NPV. A five-year bank loan at 8% is available, but the bank requires a minimum current ratio of 2.0; Kestrel's is currently 2.1 and the loan would reduce it to 1.7. The new machine would cut unit variable cost from $42 to $35 and raise capacity from 22,000 to 30,000 frames; current sales are 24,000 frames at $60. A competitor has launched a similar aluminium frame.
1. Calculate the payback period and net present value of the machine. Interpret both results against Kestrel's criteria.
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Payback
| Year | Net cash inflow | Cumulative |
|---|---|---|
| 0 | ($600,000) | ($600,000) |
| 1 | $180,000 | ($420,000) |
| 2 | $220,000 | ($200,000) |
| 3 | $200,000 | $0 |
Payback is exactly 3.0 years, which just meets the 3-year maximum. It is therefore acceptable but has no buffer.
NPV at 10%
| Year | Cash flow | Discount factor | Present value |
|---|---|---|---|
| 0 | ($600,000) | 1.000 | ($600,000) |
| 1 | $180,000 | 0.909 | $163,620 |
| 2 | $220,000 | 0.826 | $181,720 |
| 3 | $200,000 | 0.751 | $150,200 |
| 4 | $160,000 | 0.683 | $109,280 |
| 5 | $120,000 | 0.621 | $74,520 |
Total present value of inflows = $679,340. NPV = $79,340.
Interpretation
NPV is positive, so at a 10% cost of capital the project creates value. However, $79,340 is only about 13% of the outlay, and payback sits exactly on the limit. The investment is financially acceptable but not strongly so; the decision should also consider financing and strategic factors.
2. Evaluate whether Kestrel should buy the machine, considering quantitative and qualitative factors. Recommend a course of action.
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Quantitative case
At current sales of 24,000 frames, the $7 variable-cost saving is worth $168,000 a year before any volume growth. Capacity rises from 22,000 to 30,000, so Kestrel can chase the aluminium segment and reduce monthly breakdown losses. The positive NPV of $79,340 supports purchase, and payback meets policy.
Financing constraint
The bank loan would cut the current ratio from 2.1 to 1.7, below the required 2.0. The bank could refuse the loan or impose a higher interest rate. That is a serious implementation risk: a positive NPV project is useless if Kestrel cannot fund it without breaching a covenant. The 8% loan rate is below the 10% cost of capital, but the covenant may override the price advantage.
Qualitative factors
The old machine cannot make the aluminium range, and a competitor has already launched a similar frame. Delay risks losing market share and retailer confidence. The new machine also reduces disruption from monthly breakdowns, improving delivery reliability. Offsetting this, forecast cash inflows may be optimistic if aluminium demand is unproven, and the machine may become obsolete.
Recommendation
Proceed only if Kestrel can fund the purchase without breaching the current-ratio covenant - for example by negotiating a covenant waiver, using a lease, or combining retained earnings with a smaller loan. If not, delay and hire a contractor for aluminium frames. The strategic need is strong, but the financing constraint makes an unconditional purchase imprudent.