Franklin Smash Repairs Pty Ltd (FSR) is a smash repair business located in the eastern suburbs of

Sydney. The business was started by William Franklin in the late 1950s but is now run by David and Jack Franklin, the two sons of founders of the business. David and Jack each own 30% of the issued ordinary shares in the company but several other family members also own shares and the company is expected to perform well and pay annual dividends. The companys Board of Directors consists of David, who is Managing Director, Jack, their sister Amy and their cousin Grace who is the company secretary. There is one independent director and he is Richard Ellis a family friend and the family tax accountant. The company chairman is their Uncle, John Franklin who was the other founder of the company. Grace works in the business as the Accountant/Office Manager.

The smash repair business has been through some turbulent times in recent years mainly due to the increasing dominance and control exerted by the major insurance companies. FSR has survived and managed to remain profitable through the reorganisation of the industry and is a registered repairer for the major insurance companies and this ensures a steady stream of insurance work. On top of this Jack has built up a good reputation with two historic car clubs that has resulted in restoration work on vintage cars that has proved profitable and interesting work.

The company operates from premises that it has owned since the business was incorporated. At the time of incorporation it was decided to purchase two adjoining blocks of land and construct the workshop, spray booth and office on one block and keep the other as an investment or for future expansion. During the years the buildings have been renovated and updated several times with the last occasion being only sixteen months ago when a new spray booth was constructed. The workshop etc is still contained on one block. The other block is still vacant, not very securely fenced and has to be maintained by one of the local lawn mowing contractors to keep the grass and shrubs tidy. This maintenance currently costs $17,000 p.a. and is expected to increase by 3% p.a. for the next ten years. This expense will be eliminated if the site is developed. For some time now Amy and Grace have been advocating selling the land as it would release a significant amount of money which could be paid out to shareholders as a special dividend. However John has always had a dream that the land would be used to expand the business and is not keen to sell. The company is working at full capacity five days a week and Saturday overtime is not unusual. Some historical car work had to be declined recently. The major bottleneck is the spray booth where cars have to remain for a minimum drying period. The company has two spray booths but one can only be used for parts not full bodies. The company also had a problem with the parking of vehicles during the day and could only use the spare ground for parking during dry weather. In wet weather shuffling cars was not only frustrating but an inefficient use of staff time.

Some months ago John had asked David and Jack to investigate the feasibility of expanding the business and Jack has just completed an overseas trip (a combination of work and holiday with his wife and family) during which he completed some research into the latest techniques used in the smash repair business in Europe. He had also studied the latest spray booth technology and had been very impressed by a new German spray booth. The trip had been very expensive and it had cost $39,500 for airfares, accommodation and meals. As most of the trip was business the company has paid for this expense. On returning from the trip Jack met with John, Davidand Grace to outline an idea that he had been considering for some time.

Jack stated at the meeting that he believed that if the company added a new spray booth and workshop at the back of the vacant block he would be able to significantly increase business particularly in the restoration of vintage and historical cars. Car clubs were growing and keeping the cars in pristine condition was important to the enthusiasts in these clubs. FSR had built up a solid reputation for high quality work in this area and this work provided far bigger margins than insurance work. He firmly believed that FSR would also be able to take on more insurance work with the increased spraying capacity. Jack tabled a projected revenue forecast for both the historical car business and increased insurance work. The forecast revenue is detailed in Appendix 1. He also outlined some preliminary estimates on the costs involved. The building to house the spray booth and workshop would cost about $256,000 to erect. The building would be constructed on the back half of the block and the front half of the block would be converted to an all-weather car park for cars awaiting repair and customer and staff parking which would improve efficiency. The costs of the car park construction are estimated to be $74,000. The biggest cost would be the spray booth and the associated equipment. He had a firm quote from the German company and the total cost including all shipping, installation and testing would be $348,000.

John was very excited and said this was just what he had anticipated and would like to see the company at least double its size before he finally stood down as Chairman of the company. Both Grace and David were less enthusiastic. Grace argued that the company was profitable and provided a good return to the family particularly those that work in the company. A larger company would only bring more problems and Jack had not considered the extra staff that would be needed to work in the new premises. The land was very valuable and a local company had recently offered $236,000 for the block. Grace firmly believed that the company should take the money and carry on the business at current levels of activity. At this John got angry and stated that the land had only cost the equivalent of $5,000 which is next to nothing and was bought for the company to expand. He stated selling the land is not to be considered and the market value is not relevant.

David was more restrained and stated his concern was the level of investment required and raising the cash. The company certainly did not have any spare cash. The company had borrowed the amount required for the last renovations and were still making payments on the term loan from the bank. In the current climate he was concerned that additional finance of that magnitude would be difficult to obtain from the bank. He felt that a proper business plan should be produced and a short analysis prepared for all board members and the full Board should make the final decision. David emphasised that Jack and Grace should work as a team and assemble all the data required to make the decision and meet in about a month to agree on the base data to be included in the analysis. A summary of the data presented at the meeting and any relevant discussion is shown below:

1. It was agreed that the sales figures presented by Jack as shown in Appendix 1 would be used in the analysis.

2. The quote for the German machine had been confirmed in writing but they had also included an offer to train key staff to use the new technology which would cost $35,000 which FSR would take up. This would occur prior to the commencement of commercial operations and would involve a supervisor travelling to Germany. The tax office had confirmed that the $35,000 would be a tax deduction at the time the amount was paid. Grace said the company could spread this cost over ten years for accounting purposes.

3. The number of employees would be increased. At the start of the new business a new supervisor would be required for the new area. One of the current employees will be promoted. The increase in wages cost of his promotion including all on-costs will be $16,000 p.a. His current position in the current building would have to be replaced at a total cost per annum of $66,000. It was also agreed that an allowance would be made for these wages to increase by 3% p.a. Details of the wages forecast for the new employees required for the new business are shown in Appendix 1.

4. There was no additional information available on building costs and the car park construction, but it has been agreed that a 5% contingency should be included for both. Building maintenance costs for the new building are shown in Appendix 1.

5. The parts and material costs for the new business have been estimated as a percentage of revenue. The percentage for insurance work is 45% and for the historical car work is 20%. The costs of all general consumables i.e. paint, nuts, bolts cleaning rags etc. are shown in Appendix 1.

6. David has told Jack that there are old tools and equipment held in the current warehouse that could be used in the new building. Although several years old they are fully depreciated and the new project could have them at no cost. The tools had recently been appraised for insurance purposes and they have a market value of $15,000. It is estimated that by the end of 10 years, the tools will be worthless.

7. Grace has analysed the cash flow and the company would have to borrow $600,000 to finance the project. The bank has given preliminary approval but want to see a final business plan. The interest rate would be 8.25% p.a. and the loan will be repayable over 7 years with a monthly repayment figure of $9,900.

8. The company pays tax at a corporate tax rate of 30%.

9. Richard Ellis has stated that a return of 15% on an investment of this type is appropriate.

10. Land is not depreciable and no capital gains tax will apply. In ten years it is estimated that the land could be sold for about $355,000. The tax office has determined that the buildings and car park can be depreciated at 8% straight line based on cost and the spray booth can also be depreciated at 20% straight line.

11. David has asked that the project be analysed over ten years as it is very uncertain if the business will continue after that date.

12. In ten years the old tools will have no value and the spray booth would only have a scrap value of $18,000. The buildings and car park will not add to the land value at the time of sale and can be considered to have no value in ten years time.

13. There would be an increase in inventory of common spare parts at the start of the project with a value of $23,000.

14. John mentioned that the RBA had released last quarters inflation figure which was the highest it had been in three decades at 7.8%. He asks whether the assumption of a 3% increase in revenue and costs after year 4 is realistic and asks how you can incorporate the impact of a future higher or lower rate of inflation.

Your task: QUESTION

As Graces friend, she has asked you to assist her prepare a capital budgeting analysis for David and the family, along with an Executive Summary. She knows you are studying Financial Management and therefore know the correct methods for capital budgeting, including identifying the relevant cash flows and the correct treatment for them. Your submission must contain:

1. A well-presented, readable spreadsheet (i.e. with relevant detail and calculations in the cells) clearly showing an itemised breakdown (and the total) for each of the following:

i. The cash flows at the start. ii. The cash flows over the life. iii. The cash flows at the end, iv. The NPV of the project. iv. Demonstrate the impact of a change in the rate of inflation.

APPENDIX 1

Franklin Smash Repairs Revenue Forecast $

	Year 1	Year 2	Year 3	Year 4	Year 5
Historic Cars	570,000	645,000	720,000	750,000	772,500
Insurance	78,000	150,000	200,000	250,000	257,500

From year 4 onwards total revenue will only increase in line with the expected general rate of inflation which is expected to be 3%.

Wages Forecast $

	Year 1	Year 2	Year 3	Year 4	Year 5
Number of New Employees	2	3	4	4	4
Wages Cost	120,000	185,400	254,616	262,254	270,122

Note: The above figures exclude the increased cost of the supervisor and the new employee in the old building. Wages costs are expected to increase by 3% p.a. from year 4 onwards

	Year 1	Year 2	Year 3	Year 4	Year 5
Materials Historic Cars	114,000	129,000	144,000	150,000	154,500
Materials Insurance	35,100	67,500	90,000	112,500	115,875
Building Maintenance	6,000	7,500	15,000	20,000	20,600
General Consumables	64,800	79,500	92,000	100,000	103,000

Note: All the costs shown above are expected to increase by 3% from year 4 onwards