Share
Explore BrainMass

Capital budgeting-Replacement Project Analysis

The Innovative Sporting Goods Company (JSGC) was founded in 1975 in Cambridge, MA. Its founder, Andy Pratt, a mechanical engineer, had developed a sound technique of making baseball bats. Under his leadership, the company had gained national reputation. Recently, however, a new machine had been developed in the industry, which would allow manufacturers to coat the aluminum baseball bats with a special compound giving them a satin finish and making them more durable and powerful. The prototype had been presented to the respective regulatory authorities and had been approved. Upon Andy's request, Douglas Adams, the head of the design group, had tested the new product and researched the relevant cost arid production process issues that a machine replacement would entail.

Doug reported that besides the initial price tag of $350,000 for one of these machines, users would have to incur shipping, handling, and installation costs of $4500 and annual fixed operating costs of about $20,000 per machine. Currently, the company incurs fixed operating costs of $28,000 for it's coating and finishing process. Initial marketing survey results indicated that the company would be able to increase sales of its newly designed baseball bats by about 15% in the first year of introduction and thereafter at a rate of 5% per year compared with forecasted sales growth of 2% per year for the current type of baseball bats. During the most recent year, ISGC sold 220,000 baseball bats at an average price of $12.50 per unit. The newly designed bat was expected to sell for $13 per unit.

Material, labor, general, and administrative costs were expected to remain constant at $10 per unit. The increased sales and production requirements would entail an increase in accounts receivables of $54,000, an increase in accounts payables of 30,000, and an increase in inventory of $ 20,000. It was assumed that any increase in net working capital would be recovered at the end of the useful life of the machine, which was estimated to be 10 years. The existing machine was purchased 5 years ago for $225,000. The depreciation on the existing machine was being calculated using a 15-year straight-line schedule with the assumption of no residual salvage value. The machine had a current market value of $100,000, and an expected market value of $10,000 after 10 more years of use. The new machine was expected to last for ten years -- the same as the remaining life of the old machine.

The new machine would qualify as a 5-year class life asset under MACRS depreciation rates (see Table 1) and was expected to have a market value of approximately $20,000 at the end of its economic life. ISGC'S marginal tax rate was 34% and its weighted average cost of capital was estimated at 15%. Part of the cost of replacing the existing machine would be financed by a bank loan that would require an annual interest expense of 10% on the outstanding balance.

Andy knows that the new technology is the way to go. However, being cautious and conservative by nature, he does not want to implement changes that would be financially detrimental to his company. After all, he has worked too hard to let it all slip away by making lousy financial decisions. Andy has long believed in the age-old saying, " If the coat fits wear it."

Table: 1
Depreciation schedule
Modified Accelerated Cost Recovery System
Recovery Period Class

Year 3-Year 5-Year 7-Year 10-Year
1 33.00% 20.00% 14.30% 10.00%
2 45.00% 32.00% 24.50% 18.00%
3 15.00% 19.20% 17.50% 14.40%
4 7.00% 11.50% 12.50% 11.50%
5 0.00% 11.50% 8.90% 9.20%
6 0.00% 5.80% 8.90% 7.40%
7 0.00% 0.00% 8.90% 6.60%
8 0.00% 0.00% 4.50% 6.60%
9 0.00% 0.00% 0.00% 6.50%
10 0.00% 0.00% 0.00% 6.50%
11 0.00% 0.00% 0.00% 3.30%
Total 100.00% 100.00% 100.00% 100.00%

Questions:
1. Your supervisor, Vic Gonzales, has asked you to prepare a capital budgeting report indicating whether ISGC should replace the existing machine or not. Indicate how would you proceed (without making any calculations)?

2. Explain the relevance of incremental cash flows, sunk costs, and incidental costs in the context of this case.

3. As is often the case, the marketing department has overestimated the annual sales growth. How can more conservative and realistic estimates be generated? How can these estimates be incorporated into the analysis so as to arrive at a good and well justified decision?

4. What are the relevant factors and items to be considered when estimating the initial outlay? Calculate the initial outlay for this replacement project.

5. How are the interim cash flows to be computed for the productive life of the new machinery? How is depreciation to be accounted for?

Attachments

Solution Preview

See attached file for complete answers.

Book: Cases in Finance by Jim De Mello

Case: 11 "Replacement Project Analysis"

"If the Coat Fits Wear It"

The Innovative Sporting Goods Company (JSGC) was founded in 1975 in Cambridge, MA. Its founder, Andy Pratt, a mechanical engineer, had developed a sound technique of making baseball bats. Under his leadership, the company had gained national reputation. Recently, however, a new machine had been developed in the industry, which would allow manufacturers to coat the aluminum baseball bats with a special compound giving them a satin finish and making them more durable and powerful. The prototype had been presented to the respective regulatory authorities and had been approved. Upon Andy's request, Douglas Adams, the head of the design group, had tested the new product and researched the relevant cost arid production process issues that a machine replacement would entail.

Doug reported that besides the initial price tag of $350,000 for one of these machines, users would have to incur shipping, handling, and installation costs of $4500 and annual fixed operating costs of about $20,000 per machine. Currently, the company incurs fixed operating costs of $28,000 for it's coating and finishing process. Initial marketing survey results indicated that the company would be able to increase sales of its newly designed baseball bats by about 15% in the first year of introduction and thereafter at a rate of 5% per year compared with forecasted sales growth of 2% per year for the current type of baseball bats. During the most recent year, ISGC sold 220,000 baseball bats at an average price of $12.50 per unit. The newly designed bat was expected to sell for $13 per unit.

Material, labor, general, and administrative costs were expected to remain constant at $10 per unit. The increased sales and production requirements would entail an increase in accounts receivables of $54,000, an increase in accounts payables of 30,000, and an increase in inventory of $ 20,000. It was assumed that any increase in net working capital would be recovered at the end of the useful life of the machine, which was estimated to be 10 years. The existing machine was purchased 5 years ago for $225,000. The depreciation on the existing machine was being calculated using a 15-year straight-line schedule with the assumption of no residual salvage value. The machine had a current market value of $100,000, and an expected market value of $10,000 after 10 more years of use. The new machine was expected to last for ten years -- the same as the remaining life of the old machine.

The new machine would qualify as a 5-year class life asset under MACRS depreciation rates (see Table 1) and was expected to have a market value of approximately $20,000 at the end of its economic life. ISGC'S marginal tax rate was 34% and its weighted average cost of capital was estimated at 15%. Part of the cost of replacing the existing machine would be financed by a bank loan that would require an annual interest expense of 10% on the outstanding balance.

Andy knows that the new technology is the way to go. However, being cautious and conservative by nature, he does not want to implement changes that would be financially detrimental to his company. After all, he has worked too hard to let it all slip away by making lousy financial decisions. Andy has long believed in the age-old saying, " If the coat fits wear it."

Table: 1
Depreciation schedule
Modified Accelerated Cost Recovery System
Recovery Period Class

Year 3-Year 5-Year 7-Year 10-Year
1 33.00% 20.00% 14.30% 10.00%
2 45.00% 32.00% 24.50% 18.00%
3 15.00% 19.20% 17.50% 14.40%
4 7.00% 11.50% 12.50% 11.50%
5 0.00% 11.50% 8.90% 9.20%
6 0.00% 5.80% 8.90% 7.40%
7 0.00% 0.00% 8.90% 6.60%
8 0.00% 0.00% 4.50% 6.60%
9 0.00% 0.00% 0.00% 6.50%
10 0.00% 0.00% 0.00% 6.50%
11 0.00% 0.00% 0.00% 3.30%
Total 100.00% 100.00% 100.00% 100.00%

Note: represents the extracts from the case
( ) have been used in the extracts to complete the meaning

Questions:
1. Your supervisor, Vic Gonzales, has asked you to prepare a capital budgeting report indicating whether ISGC should replace the existing machine or not. Indicate how would you proceed (without making any calculations)?

The steps in capital budgeting are:
?Proposal Generation
?Review and Analysis
?Decision Making
?Implementation
?Follow-up

Therefore the report should include
?Proposal Generation involves identification of potential investment opportunities.
Here the investment opportunity is the purchase of new machine
a new machine had been developed in the industry, which would allow manufacturers to coat the aluminum baseball bats with a special compound giving them a satin finish and making them more durable and powerful.

?Review and Analysis
Here the proposal is reviewed and analysed. The report would include all the relevant cash flows associated with the purchase of new machine.

?Decision Making
Here the report would use the NPV method to arrive at the decision whether to replace the old machine with the new machine.

?Implementation
Here the report would indicate how the new project would be implemented . This would consist of a complete formulation of project, recommendation for development of a system of responsibility accounting etc.

?Follow-up
Here the report would indicate the mechanism of performance review.

2. Explain the relevance of incremental cash flows, sunk costs, and incidental costs in the context of this case.

From the case:
Recently, however, a new machine had been developed in the industry, which would allow manufacturers to coat the aluminum baseball bats with a special compound giving them a satin finish and making them more durable and powerful. The prototype had been presented to the respective regulatory authorities and had been approved. Upon Andy's request, Douglas Adams, the head of the design group, had tested the new product and researched the relevant cost arid production process issues that a machine replacement would entail.

Therefore the current case deals with a replacement decision: whether to replace the existing machine with the new machine.

incremental cash flows:
Cash flows must be measured in incremental terms. This means that the changes in the cash flows of the firm which can be attributed to the project alone are relevant. According to incremental analysis only the difference due to the decision need to be considered. With replacement projects, incremental cash flows are calculated by subtracting existing project cash flows from those expected from the new project.

The relevant cash flows are:
"Initial investment= Initial investment needed to acquire new asset + Increase in working capital requirements with the new assets-After tax cash inflows from liquidation of old asset
Operating cash inflows=Operating cash inflows from new asset - Operating cash inflows from old asset
Terminal Cash flow= After tax cash flows from termination of new asset + Recovery of working capital requirements - After tax cash flow from termination of old asset
"

From the case:
The relevant cash flows for initial investment are:
"Doug reported that besides the initial price tag of $350,000 for one of these machines, users would have to incur shipping, handling, and installation costs of $4500. (The existing ) machine had a current market value of $100,000. The increased sales and production requirements would entail an increase in accounts receivables of $54,000, an increase in accounts payables of 30,000, and an increase in inventory of $ 20,000.

"

Initial investment needed to acquire new asset is:
Doug reported that besides the initial price tag of $350,000 for one of these machines, users would have to incur shipping, handling, and installation costs of $4500.

The increase in working capital requirement is
The increased sales and production requirements would entail an increase in accounts receivables of $54,000, an increase in accounts payables of 30,000, and an increase in inventory of $ 20,000.

Cash flow from sale of old asset is:
(The existing ) machine had a current market value of $100,000.

The relevant cash flows for operating cash inflows are:
(The new machine would have an) annual fixed operating costs of about $20,000 per machine. Currently, the company incurs fixed operating costs of $28,000 for it's coating and finishing process.Initial marketing survey results indicated that the company ...

Solution Summary

Capital Budgeting Case, "Replacement Project Analysis" from Cases in Finance by Jim De Mello is discussed and the questions from the case have been answered.

$2.19