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1. Benefits and risks
(1). Controlled quality
By choosing option 3, Stryker Corporation can control the quality of PCB by itself. PCB manufactured in its own facility can meet Stryker’s quality requirement better than those from different contract manufacturers. Moreover, the quality can be more stable. Stryker would not suffer from the risk of contract manufacturers’ bankruptcy any longer.
Reduced cost and higher efficiency
Stryker Corporation can relief its human resource from looking for new suppliers and greatly reduce management cost spent on this issue. Stryker will also benefit from shorter delivery time and less cost since the facility is close to its headquarters, which means higher efficiency and more competitive strength. To in source PCBs, Stryker only needs to deal with material suppliers instead of many small and unstable manufactures. The communication cost will go down.
Longer payable period
Payable period will extend, which will lay less stress on Stryker‘s working capital because the longer the accounts payable period, the shorter the cash conversion cycle.
In-sourcing PCBs will bear risks at the same time. First issue is that whether PCBs will be replaced by new technology and then investment in facilities can be valueless. We forecast the project needs decade to get a positive NPV but chances are that PCBs could be eliminated by industry.
(2). Insufficient production capacity
If PCBs technology can stand that long and Stryker Corporation’s demand of PCBs keeps increasing there are still risks that the demand exceeds the facility’s capacity. That means Stryker will find itself fall into a situation as they did before in-sourcing and go back to looking for new manufacturers to meet the exceeded demand for PCBs.
2. After analyzing the benefits and risks of the in-sourcing project, we need to calculate the exact incremental cash flow and NPV to help Stryker Corporation decide whether to take option 3# into action. In order to measure the value of this project precisely, we need to know the FCF in each year and the exact time horizon for this project. Finally we should discount FCF in each year to calculate the NPV of project. Below are two equations we needed to calculate the FCF and NPV:
From the case, we can conclude that Stryker Corporation makes the initial investment in 2003, so we make 2003 to be the year 0. According to the hardware (PCB) life cycle model, we assume that the project will last 8 years from 2004 to 2012. However, the case only present the data from 2004 to 2009, so we need to predict the FCF from 2010 to 2012. Thus we divide our calculation into two parts, the first part is 2003-2009, and the second part is 2010-2012. Our job is to figure out four parts in equation (1) of the case to calculate the free cash flow in each year. And then, use the time horizon we assumed to calculate the NPV of this project by using equation (2). So let us begin with the first part.
(1) Period from 2003-2009:
Firstly, let us start with the CapEx part in equation (1) since it only happens in the first year. In this case, the initial investments that Stryker Corporation make to build the capital should be counted as capital expenditure. So, the CapEx part should include the expenditure for site preparation, construction and improvements ($3,030,000), furnishings and non-manufacturing equipment ($126,000) and communication equipment and IT infrastructure ($210,000). All of which are depreciable in the future.
Secondly, let us deal with the EBIT part. Since the difference between out-sourcing and in-sourcing strategy is only reflected on the costs. We can consider the decrease in purchases from contract manufacturers as cash inflows and consider the total manufacturing cost as cash outflows. All these data are presented in Exhibit 2. One important thing to mention is that, in the initial investment, the architectural and engineering fee ($278,000) is treated as expense in year 0 so it is also treated as cash outflows in EBIT. Since all these EBIT are tax deductible, we tax those incremental EBIT by the rate of 36% to get the unlevered net income.
Thirdly, let us deal with the depreciation part. The items that need depreciations include the expenditure for site preparation, construction and improvements ($3,030,000), furnishings and non-manufacturing equipment ($126,000) and communication equipment and IT infrastructure ($210,000) and capital expenditure ($2,643,258). From the case we know, the building would be ready in April, 2004 with a 30-year lifetime. So the expenditure for site preparation, construction and improvements ($3,030,000) should be depreciated from April, 2004 for 30 years(each year $101,000) and the depreciation expense in 2004 will be three quarters of depreciated value in other years. Also, the capital equipment ($2,643,258) should be depreciated from July, 2004 for 7 years (each year $377,608) and the depreciation expense in 2004 will be half of depreciated value in other years. Finally, the IT and other furnishings ($210,000+$126,000=$336,000) should be depreciated form April, 2004 for 3 years (each year $112,000) and the depreciation expense in 2004 will be three quarters of depreciated value in other years.
Finally, let us deal with the NCW part. From the case, the change in NCW only reflects on the change in A/P. Combine the four tables to calculate the FCF from 2004 to 2009.
(2) Period 2010-2012:
Since the capital expenditure and IT& other furnishing will be fully depreciated before 2012. So, the first assumption we made is that the Stryker Corporation will take the building, which is the only left capital, into other use and will not sell it. Also, the case illustrates that the facility’s rated capacity will reach 100% in 2009 so that the volume of the production will not increase after 2009. In this case, we can make the second assumption that the manufacturing cost, the decrease in purchases and the change in A/P will only be influenced by the inflation. Under these two assumptions, all we need to do is to estimate the inflation rate between 2010-2012. We can see from the Exhibit 4 that in May 31, the 5-year interest rate is 2.52% and 10-year interest rate is 3.57%. Since the treasury bond is compounded semi-annually, we need to adjust the interest rate yield to EAR: For 5-year bond: EAR:=2.535%
For 10-year bond: EAR:=3.601%
The estimated inflation rate= -1= 2.09%
After getting the estimated inflation rate, we need to forecast the manufacturing cost, the decrease in purchases and the change in A/P based on the data in 2009 and the estimated inflation rate. Also, the residual value of building and the capital expenditure will be depreciated through 2010-2012.
As we work out the four parts in equation (1) from 2010-2012, we can combine the four tables to calculate the FCF from 2004-2012.
3. After getting the FCF in each year, we should NPV mentioned in equation 2 by using the hurdle rate (15%). Using the “NPV” command in excel, we can get the NPV of the PCB In-sourcing project, which is $ 5190234.44.
4. Calculated with the assumption that NPV=0, we can use the “IRR” command in Excel to get the IRR of the PCB In-sourcing project, which is 26.48%.
5. Since the NPV is positive and the IRR (26.48%) is higher than the hurdle rate (15%), we think that the Stryker Instruments should fund this project.