Compute and compare the net present value and payback period of each option

INTRODUCTION

It was another sleepless night for Brian French. As a new

father, French had grown accustomed to sleep deprivation,

but on this night, it was his business—not his newborn

daughter—that had him tossing and turning. French was

the president and co-owner of Peregrine, a Vancouver-

based manufacturer of custom retail displays that were used

in stores, banks, and art galleries (Exhibit 1). Peregrine

had been working on a display for Best Buy when one of

the company’s two computer-numerical-control (CNC)

machines broke down (Exhibit 2). When the machine went

down, French watched progress on the Best Buy job slow

to a halt. Although French had been assured that the CNC

machine would be back up and running within 24 hours, the

breakdown revealed a deeper problem: the CNC machines

represented a major bottleneck for Peregrine, and if this

machine was down for more than the promised 24-hour

period, the Best Buy job could not be completed on time,

and workers would need to be sent home. French was

frustrated by this predicament and was determined to make

the changes necessary to ensure it would not happen again.

PEREGRINE

In 2012, French left PricewaterhouseCoopers to purchase

Peregrine along with two co-investors. The investment

team had been looking for an opportunity to purchase a

company with a successful track record and a founder who

was ready for retirement; Peregrine had fit the bill. Founded

in 1977, Peregrine had been operated profitably for 35 years

in downtown Vancouver, British Columbia, Canada. In

Peregrine, the investors would be acquiring a company with a

history of success and an experienced team that had expertise

in manufacturing a wide array of custom plastic products.

When Peregrine was acquired in 2012, it had employed

6 people and had $600,000 in sales. Under French’s

management, the company had grown to more than 30

employees and more than $6 million in sales by 2016.

THE CNC MACHINE DECISION

When the CNC machine broke down, it was a wake-up call

for French. The production line was dependent on both

CNC machines working full time—if they slowed down or

needed repair, the business suffered. French believed the

key to relieving this bottleneck would be increasing capacity.

It not only would prevent downtime but also would allow

the company to take on new business. If capacity increased,

French estimated that sales revenues would rise by at least

$50,000 per month due to unmet demand and increased

efficiency. The company’s margins on the additional

revenues were expected to be 35%. French saw three viable

options to increase capacity:

1. Purchase an additional CNC machine for cash,

2. Finance the purchase of an additional CNC machine, or

3. Add a third shift (a night shift) to better utilize the two

CNC machines Peregrine already owned.

IMA EDUCATIONAL CASE JOURNAL VOL. 10 , NO. 3 , ART. 1 , SEPTEMBER 20171

ISSN 1940-204X

Peregrine: The CNC Machine Decision Tony Bell

Thompson Rivers University

Dr. Andrew Fergus

Thompson Rivers University

©2017 IMA

French considered the details of each option, keeping in

mind that for long-term projects he would use a discount rate

of 7%.

OPTION 1: PURCHASE A NEW CNC MACHINE WITH CASH Although it would be costly, the idea of adding a third CNC

machine appealed to French. It would provide him peace of

mind that if there were a breakdown, jobs would continue

on schedule. French’s preliminary research revealed that

the cost of the new equipment would be $142,000. He also

estimated that there would be increased out-of-pocket

operating costs of $10,000 per month if a new machine were

brought online. After five years, the machine would have a

salvage value of $40,000. Although Peregrine did not have

the cash readily available to make the purchase, French

believed that with a small amount of cash budgeting and

planning, this option would be feasible.

OPTION 2: FINANCE THE PURCHASE OF A NEW CNC MACHINE The company selling the CNC machine also offered a

leasing option. The terms of the lease included a down

payment of $50,000 and monthly payments of $2,200 for five

years. After five years, the equipment could be purchased

for $1. The operating costs and salvage values would be the

same as option 1, the purchasing option. The company had

the necessary cash on hand to make the down payment for

the lease. With both the leasing and purchasing options,

the company had sufficient space to operate the new

equipment, and French believed he had almost all of the

right employees in place to execute this plan.

OPTION 3: ADD A THIRD SHIFT French and one of his co-investors had extensive experience

in the trucking industry and had seen firsthand the effect

of utilizing equipment around the clock. French believed

adding a third shift could unlock a lot of value at Peregrine,

and it could be done at a low cost. Adding a third shift would

involve moving several existing employees to work the night

shift and would also mean hiring some new employees.

Although French believed that in time he may add a full

third shift to increase overall capacity, his initial plan was for

the night shift to run as a “skeleton crew” with the primary

purpose of keeping the CNC machines operational for 24

hours. He believed that adding a third shift would produce

the same increase in revenue as adding a new CNC machine

to his existing shifts. He estimated that adding a third shift

would create $12,000 in additional monthly out-of-pocket

operating costs, but no new machinery would need to be

purchased. Based on his trucking experience, French knew

this option would be difficult to execute, as there were major

safety and supervision challenges associated with running a

night shift.

MOVING FORWARD

French wanted to get moving on a solution and arranged

a conference call with his two co-owners. He knew his co-

owners would be eager to learn the numbers behind each

option, but he also knew that nonfinancial information would

be just as crucial in making a recommendation. Before the

call, French sat down at his desk to fully analyze the options.

ASSIGNMENT QUESTIONS

1. Without using any numbers, identify the strengths and

weaknesses of the three options identified by French.

Are there any other options French should consider?

2. Compute and compare the net present value and payback

period of each option.

3. Make a recommendation for French.

4. Rounding to the nearest 1%, at what discount rate does

leasing produce a higher net present value than paying

cash?

IMA EDUCATIONAL CASE JOURNAL VOL. 10 , NO. 3 , ART. 1 , SEPTEMBER 20172

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IMA EDUCATIONAL CASE JOURNAL VOL. 10 , NO. 3 , ART. 1 , SEPTEMBER 20173

Exhibit 1. Examples from Peregrine’s Portfolio

Vancity Sign lululemon Storefront

Display Case in the Vancouver Art Gallery Phone Display Cases and Stands at Telus

Sign and Display Tables for Simply Computing TED Sign at the Vancouver TED Conference

Source: http://www.peregrine.build/portfolio/

IMA EDUCATIONAL CASE JOURNAL VOL. 10 , NO. 3 , ART. 1 , SEPTEMBER 20174

Exhibit 2. CNC Machine

One of Peregrine’s CNC machines—a flatbed nesting router.

For a video demonstrating the capabilities of this type of machine, visit

www.youtube.com/watch?v=NY-nGT8_ZcQ.