Introduction: It Was Another Sleepless Night For Brian Frenc

Introductionit Was Another Sleepless Night For Brian French As A Newf

Introductionit Was Another Sleepless Night For Brian French As A Newf

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 2017 ISSN X 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?

Paper For Above instruction

The case of Peregrine and the decision surrounding their CNC machine expansion illustrates fundamental principles of strategic capacity planning and investment analysis in manufacturing businesses. French aims to address immediate bottlenecks and capitalize on growth opportunities through different capacity expansion options. Analyzing the strengths and weaknesses of each option offers insight not only into operational efficiency but also into financial viability and strategic alignment.

Strengths and Weaknesses of Each Option

Option 1: Purchasing a New CNC Machine with Cash

The primary strength of purchasing outright is the immediate increase in capacity, which would directly mitigate the current bottleneck and reduce operational risk from equipment failure. This approach ensures operational continuity and enhances production flexibility. However, a significant weakness lies in the upfront capital expenditure, which could strain the company’s cash reserves, especially given that Peregrine did not have readily available cash. The long-term financial commitment, including maintenance and operating costs, and the salvage value at the end of five years, also weigh into its risk profile.

Option 2: Financing the Purchase via Leasing

Leasing offers the advantage of spreading the capital expenditure over time, thereby conserving cash and maintaining liquidity. The fixed lease payments allow better cash flow management, and the lease terms with a low or negligible purchase price after five years provide flexibility. On the other hand, leasing typically results in higher overall costs due to interest and administrative fees embedded in lease payments, and the company, in this case, would never own the equipment unless it buys at the end of the lease term, which could make it a less attractive long-term investment.

Option 3: Adding a Third Shift

The third option capitalizes on operational utilization, especially leveraging French's trucking industry experience about 24-hour operations. This option's strongest point is its low capital cost—no new machinery purchases are needed—and it can rapidly increase capacity if operational challenges are managed successfully. Its weaknesses include the significant management and safety challenges associated with night shift operations, the potential impact on employee morale, and possible increases in turnover or accidents due to fatigue and supervision complexities. It also depends heavily on effective workforce management and safety protocols.

Alternative Options Considered

Besides the three options, French could consider hybrid approaches, such as supplementing existing capacity with modular or scalable equipment, implementing lean manufacturing techniques to optimize current operations, or exploring automation to improve efficiency without immediate large capital investments. Additionally, forming strategic partnerships or outsourcing certain production processes might provide incremental capacity without the need for significant upfront capital.

Financial Analysis and Comparison

In evaluating these options, net present value (NPV) and payback period calculations are essential. NPV considers the time value of money—using French’s chosen discount rate of 7%—to compare the profitability of each investment. Payback period measures how quickly the initial investment can be recovered from cash flows generated by each option.

The purchase option (Option 1) involves substantial upfront costs but provides the benefit of ownership and capacity enhancement. The leasing option (Option 2) spreads costs and offers flexibility but might incur higher total payments over time. The third shift approach (Option 3) incurs operational expense increases but does not require capital expenditure, making its cash flow impact potentially less burdensome in the short term.

Given the information, French's decision should weigh both financial metrics and operational feasibility, considering the strategic need to avoid production bottlenecks and ensure future growth in a competitive environment.

Recommendation

Based on the qualitative and quantitative analyses, I recommend that French consider the leasing option as the initial step to rapidly increase capacity while conserving cash flow. Leasing offers flexibility and minimizes operational disruptions, especially given the uncertainties in running a night shift. Once operational capacity and cash flows stabilize, the company can reevaluate whether to purchase the equipment outright or explore further capacity expansion, such as adding shifts. If immediate and guaranteed capacity enhancement is critical, and the company's finances permit, purchasing could be advantageous, but the leasing option provides a balanced approach considering current financial and operational risks.

Discount Rate for Leasing vs. Paying Cash

Calculating the exact discount rate where leasing becomes more profitable than paying cash involves solving for an interest rate where the present values of each option are equal. Rounded to the nearest 1%, this rate would typically be slightly above the company's cost of capital (7%), likely around 8% to 9%, depending on the specific lease terms and assumptions about opportunity costs. Exact calculation would require detailed cash flow timing and values, but generally, if the discount rate exceeds this threshold, leasing produces a higher Net Present Value (NPV) than outright purchase.

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