case study:

Background

Magic Timber and Steel $($Magic$)$ is a small business in Caloundra, Australia founded in $1999$

Originally sold discounted timber packs, then expanded into a timber yard and hardware supplies

Experienced rapid growth in the $2000$s due to population boom and residential construction on Sunshine Coast

Revenues peaked around $2011$ at $$945,000,$ but have since declined to $$730,000$ in $2015$ due to infrastructure issues, tourism decline, slowing population growth

Owner John Davidson attributes revenue decline to economic factors and new competition from Bunnings Warehouse big box store

The Issue

Magic's older timber finishing machine, the Matrix $750,$ is becoming unreliable and needing repairs

A competitor offered $$35,000$ to buy the $15-$year old Matrix $750$ from Magic

If kept, Matrix $750$ would require $$28,000$ in immediate repairs, $$7,000$ in annual maintenance

After $5$ more years Matrix $750$ would be scrapped for $$5,000$

Davidson believes investing $$135,000$ in a new Delta A$390$ finishing machine could revive Magic's fortunes

Delta A$390$ offers $40\%$ increase in capacity and reduced operating costs

However, it requires taking on significant debt that is concerning given competitive threats

Existing Machine Details

Matrix $750$ was purchased used when $5$ years old, now $15$ years old

Safety issues $-$ prone to kick back if lumber not positioned correctly

If kept, $$28,000$ in immediate repairs needed, $$7,000$ in annual maintenance

After $5$ more years, Matrix $750$ would be sold for scrap value of $$5,000$

Current book value is $$35,000-$ competitor offered this amount to buy it

New Machine Details

Delta A$390$ costs $135,000$

Would be financed with $5-$year interest$-$only loan at $6\%$ from Magic's bank

Principal repayment of $$135,000$ due at end of $5$ year term

Delta A$390$ capacity is $40\%$ higher than Magic's needs currently

Provides opportunity for some custom work for specialty woodcrafters

Delta A$390$ can be depreciated at $10\%$ annually, sold for $$70,000$ after $5$ years

Seller offered maintenance plan: $$2,000$ in Year $1,$ increasing by $$1,000$ annually

Expected Cost Savings

$10\%$ labour cost reduction in Year $1($from $$30/$hr$),$ increasing by $$250$ each year

$10\%$ electricity savings in Year $1($currently averages $$5,625/$hr$),$ increasing by $$75$ annually

Davidson's Concerns

Large amount of debt required for Delta A$390$ concerning given market uncertainty

Added capacity may not be fully utilized depending on competitive conditions

Declining revenue trend likely to continue without investment in improved capabilities

However, debt obligations difficult to meet if new business does not arise

Key Uncertainties

Will added capacity be fully utilized given competitive threats?

Can new business be acquired to leverage capabilities of Delta A$390?$

Will cost savings from Delta A$390$ be enough to offset loan payments?

Is taking on large debt burden too risky given Magic's declining revenues?You may consider the following guided questions to prepare your report. If you have made assumption$($s$)$ as part of the case analysis, please include them in the report.

Using NPV analysis, should Magic Timber and Steel $($Magic$)$ purchase the new Delta finishing machine?

What other quantitative and$/$or qualitative factors $($see below$)$ need to be taken into consideration?

Sensitivity analysis $($e$.$g$.,$ different discount rates, different selling prices, change in maintenance cost$)$

You may assume discount rate as $10\%$ and tax rate as $30\%.$

Cash Flows:

Matrix:

Salvage value, Repair, Maintenance, Scheduled service, Machine Sales

Delta:

Machine investment, Labour savings, Electricity savings, Maintenance, Salvage value, Profit$/$Loss from sale

Non$-$Cash Flows:

Matrix:

Depreciation $($given in case$)$

Delta:

Depreciation $(10\%$ per year of cost $$135,000)$

Tax Impact relevant Cash Flows:

Which of the above cash flows and non$-$cash flows could impact the cash flow for tax saving$/$payment$?$

Savings $(+$ taxable income$),$ Costs $(-$ taxable income$),$ Depreciation $($Matrix$,$ Delta$),$ Profit$/$Loss from Sale

Cash Flows for NPV:

Which of the above cash flows $($including tax impact relevant cash flows$)$ are relevant for purchase of Delta decision?