FIN 3100 Principles of Finance

Alexander's Custom Ceramics

Capital Budgeting Case Study

The last pieces of the twenty-foot-long decorative brick wall were just coming out of the firing kiln. Gregory Alexander jumped as the telephone rang, dropping the last brick for the wall, but fortunately, it did not break. Greg answered the phone. It was Bryan Reynolds, a loan officer from the bank.

"Your loan has been approved" Reynolds said. "Just come in and sign the papers and you can order your new kilns."

Reynolds had really gone to bat for Greg at the bank to get his loan approved. He had been a satisfied customer from way back. Four years ago, when Reynolds bought his "dream house" in Mapleton, he had been exceptionally impressed by an interior wall of relief sculpture done in brick. He contracted Greg to do another relief sculpture and a mosaic tile work and was favorably impressed by both.

In fact, it was Reynolds' suggestion that Greg consider expanding the business. Initially, Greg had considered himself to be a "starving artist," making enough money to survive while doing the work he loved to do: work with ceramic arts. He had not counted on a continuing stream of contracts from Mapleton's prestige-seeking residents. Initially, he had worked on a few small projects for extra money while running a craft shop just north of Mapleton. He sold ceramic items custom made by him, and products made by other local artists.

A milestone event happened five years ago, however. A shop patron who Greg really didn't like had seen some of the small projects Greg had done for an executive for the Castle Valley Country club, and "just had to have" an original brick work in her new house, as well. Greg, not wanting anything to do with the customer, quoted a ridiculously high price for the requested work. To Greg's surprise, she had written a check for half of his price, and said she would pay the rest upon completion of the job. Word of mouth soon found Greg enjoying plenty of brick and mosaic jobs at premium prices. He had a six month backlog of work, and was running his ceramic kiln all day, every day, except for increasing downtime when the kiln needed maintenance and repair.

The need for new production equipment and employees to handle the non-artistic aspects of the business became increasingly apparent. Greg felt the he could meet his current demand, and even expand his business by investing in better production equipment. He had also considered making molds for certain designs that had special appeal, and producing limited runs of the designs. It would not be custom artwork, but Greg felt there may be demand for limited run brick art.

"We have also arranged for a working capital loan and a line of credit for you," Reynolds said. "The loans will be secured by the equipment and by your property in Payson." Payson was a small community about ten miles from Mapleton, where Greg owned a house and seven acres of land, a family property he had inherited free of mortgages.

"Thank you, Mr. Reynolds. I'll be in touch," replied Greg.

Equipment

One of the decisions that Greg had wrestled with was the choice between an electric and a gas-fired kiln. Greg had used an electric kiln for years, and had been pleased with their ease of firing thin flat ceramic objects, such as tile or thin brick fascia, or tall pieces requiring even heating. Greg liked the idea than no flammable gas was used, and that all he had to do was turn the kiln on to start the process. The problem with his electric kiln was that it was very expensive to run. Using electricity to provide heat was not very cost effective, he thought, and he was concerned that a high capacity electric kiln would be prohibitively costly to run. The kiln had also been fairly costly to maintain and repair.

Gas fired kilns had nice features that offset the electric kiln's problems. For one thing, the heat was much more uniform within the kiln, creating more consistency for the product. Temperature control was easier and quickly adjusted. Certain glazing colors were possible with gas fire that were not possible with electric heating. Gas kilns typically were available in a wider variety of sizes, and large production kilns could yield large quantities of product quickly. One of the best features of the gas kiln was that it was cheap to operate. One of Greg's fellow artists in Spanish Fork said that he ran his 92 cubic foot kiln for only $47.10 per burn, on average. That is about half the cost of a burn in an electric kiln.

What Greg was considering was a "bank" of three gas units, each having a 78 cubic foot capacity. Greg reasoned that small production runs could be handled by one or two kilns, but he could also run all three for large jobs. The gas kilns were $27,000 each, a total investment of $81,000 plus around $4,800 for installation, setup, and safety testing. Greg figured that if he went to gas firing, he certainly wanted them to be as safe as possible.

The same volume capacity could be accomplished with twelve electric units, costing $3,750 each. The installation and setup would be only $800 for an industrial electric service. Greg was not looking forward to having to set up all twelve units for a large job. He also had concerns that the quality (uniformity) of the product would suffer, not only because of the inconsistencies within the single units, but also because of differences between the units.

The only information Greg had to assist in the decision was an operational cost summary provided by Production Testing Service, Inc., which had estimated energy usage under normal running conditions. Fortunately the information was available for both types of kilns he was considering. He felt certain that the numbers had meaning. His limited understanding of analytical matters, however, handicapped him in terms of understanding their significance.

Although his financing package was approved by the bank, he wondered whether Reynolds' insistence about his approval was justified by the feasibility of the planned expansion. He also wondered about which kiln alternative was better in the long run. Greg freely admitted that he was not a very effective businessman, and had no idea about how to determine if the investment would provide a satisfactory result to him. He felt very felt very fortunate that he had developed a reputation that allowed him to have such a substantial gap between the price he charged and the direct cost of the raw materials and the operating costs. Greg was a bit uneasy about borrowing, especially if he had to pledge the family home as collateral.

When asked about tax expense Greg states that his business is organized as an LLC so that all of the net income is passed through to his personal tax return and that personally his marginal tax rate is 28% on the Federal level plus 5% for state income taxes.

When asked about the rate of return goals that he has for the investment Greg believes that after accounting for all of the financing costs he needs to earn at least 10% to make the expansion worth the effort.

The Question

Greg had been advised by Mr. Reynolds about the importance of projected sales and expense information when applying for a business loan. Greg had provided Reynolds with some cost projections. Greg felt the projections were realistic; he had been fairly conservative, understanding his expected sales amounts and overstating his expected expenses slightly (see Exhibit 4). He was unsure about the extra utilities expenses associated with either type of kiln, but had provided Reynolds the other figures. That was part of the reason Greg was puzzled by the sudden loan approval. Had Reynolds done some kind of analysis of Greg's figures or had he just pushed the loan through?

Greg has been referred to you by a mutual friend and he has asked you to analyze his situation and assist him with his decision. Among the things he has asked you to do are:

1. Using the information included in this case calculate the future incremental after-tax operating cash flows for both projects.

2. Evaluate both alternatives using appropriate capital budgeting decision criteria.

3. Prepare a letter explaining the analysis you performed, including; how you calculated the cash flows; what capital budgeting methods you used, why they are important, and what they tell you; and a recommendation to Greg of whether or not he should move forward on the project and if yes, which kiln he should buy and why.

Please submit both your report and the Excel file in Canvas.

Good luck!

Exhibit 1.Production Testing Services, Inc. Data

Model 10/92 Gas Fired Kiln

Fuel Type Capacity Fuel/Ave. Use Unit Cost

Propane 78 cu. ft. 15.6 lb./burn $2.498/lb.^*

General Lee 20 Electric Kiln

Fuel Type Capacity Fuel/Ave. Use Unit Cost

Electric 220/3 18.9 cu. ft. 5.986 kwh/burn $3.46/kwh^**

* lb. represents a standard measure of a unit of liquid propane, a pound.

** kwh represents a standard measure of a unit of electric power, a kilowatt hour.

Exhibit 2. Income Statements

Exhibit 3. Balance Sheets

Exhibit 4. Sales and Cost Projections

• Productivity and capacity are assumed to be the same for either kiln type (12 electric units versus 3 propane gas units).
• The quality level of both kilns is acceptable.
• The project's useful life is 15 years. At the end of the project Greg believes that the kilns could be sold for about 25% of their original cost.
• Depreciate the new kilns to zero over 8 years using straight line depreciation..

• Sales projections: An additional $176,000 in revenue from the new kilns (calculated as 22 additional jobs at $8,000 per job).
• 22 additional kiln firings per year (over and above the current production level).
• The inventory level will increase by about $60,000 in the first year.

• Incremental Operating Expense Projections
• $70,400 more in cost of goods sold.
• No additional car/truck expenses.
• $500 more in advertising.
• $2,200 more in insurance expense.
• $600 more in repair expense.
• No change in rent.
• Higher depreciation expense to be calculated using straight line depreciation.
• $800 more in supplies expense.
• $5,000 more in wages expense.