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CASE 21 FRANKLIN LUMBER CAPITAL BUDGETING PROCEDURES Pete Parker, the owner and CEO of Franklin Lumber, is being quite frank with Courtney Jones, a recent hire. "As I told you at our interview, I'm hiring you despite your MBA. I haven't had good experiences with MBA's. They tend to be too technical, lack communication skills, and view problems as mere aca- demic exercises. But you seem to be different. Your recommendations cited your sensitivity to real-world complexities and I've been impressed with your communication and people skills. I think you can help us." Jones received her MBA four weeks ago from a southern university with a strong regional and a bit of a national reputation. She received a number of "big city" job offers but turned them down to accept a position with Franklin Lumber, a firm based in Lenoir, North Carolina. The company has four plants in the southeast, and primarily manufactures lumber that is used to produce various types of furniture such as desks and doors. Jones took the job because she wanted a position with a small firm where she "could make a difference," the company is located very near her family, and the compensation is surprisingly attractive. She is also impressed with Parker. Though a bit gruff, he seems sharp, fair, direct, and willing to give her much job freedom and responsibility. In fact, her first assignment is of some importance and consists of two parts. Parker wants Jones to (1) perform a financial evalua- tion on two new machines that he is considering and (2) "critique" the com- pany's capital budgeting policies. PLYWOOD PRESSES The plywood division is an important component of the firm's business and nearly two entire plants are devoted to the production of plywood panels. In 130 PART V CAPITAL BUDGETING brief, the production process involves gluing a thin layer of wood to each side of a particle board that forms the core of the plywood. The plywood is then cut into panels of various sizes suitable for the manufacturing of furniture. The plywood division is operating very close to capacity and Parker is seri- ously considering the purchase of an additional plywood press in order to expand the division's production capability. He has narrowed the choice to two models: the Nakoi, which is made in Japan, and the American-manufactured Dakota The Nakoi costs $750,000 and the Dakota $1,300,000, both figures including installation. The Dakota has three advantages over the Nakoi. First, because it is a bit faster its daily production rate is higher, and Parker is confident he could sell the extra output. Second, labor costs will be lower since it is easier to oper- ate. Finally, the Dakota should hold its value better because it is a more state of-the-art press. Still, the Dakota is nearly twice as expensive and Parker isn't sure these advantages are worth the extra cost. Exhibit 1 shows information on each machine. For the purpose of analysis, straight-line depreciation will be used over the seven-year time horizon of the project. The relevant tax rate is 40 percent. The purchase of either machine will cause a modest increase in inventory and receivables. Parker thinks that these increases will be almost completely offset by changes in accounts payable and accruals. Thus, on balance, working capital requirements for both machines will be negligible and can be ignored in any evaluation PARKER'S FAPG Parker then explains his capital budgeting practices, which he calls his fixed asset purchase guidelines (FAPG). The first step is to make sure that a proposal fits with the company's mission. Parker is simply not interested in projects outside the lumber industry." He is quick to add that nearly all proposals fall within the industry though occasionally one "seems far-out." As an example, Parker recalls a suggestion that the firm buy a local convenience store. "No way I'd do this. After all, I have enough headaches with the lumber industry. One industry is about all I can handle." For relatively small investments the company relies exclusively on the pay- back method. There is no set guideline but Parker admits that he wants to see "at least a two-year payback, three years tops." And he defines a "small invest- ment" as a project less than $10,000 and "maybe as much as $15,000." Examples include the replacement of relatively inexpensive equipment and the installa- tion of energy-saving devices. Parker uses somewhat different techniques for more expensive proposals, such as a plant modernization, an expansion, or the purchase of a new plywood press. The payback is still used in part because Parker uses it as a measure of risk, and in part because it is simple to calculate and easy to understand. CASE 21 FRANKLIN LUMINER 131 He also wants a measure of the project's expected retum and based on the suggestion of a friend with a strong accounting background--the firm calcu lates the investment's average accounting rate of return (AAR). The AARR is determined by dividing the project's average annual net income by its average book value. An example of the AARR is presented in Exhibit 2 In order to be acceptable, a relatively large investment must pass two bests. First, the AARR must exceed the firm's target book return. This book return is currently 20 percent, the figure that Parker uses to evaluate the performance of the firm's plant managers In addition, the project must have an acceptable payback Parker explains, "I use my judgment about what is an acceptable' payback. There are no strict guidelines." He admits, though, that he doesn't like to see a project's payback exceed five years. FORECASTING ACCURACY In Parker's view the most important part of a capital budgeting decision is the accuracy of the forecasts, and he goes to great lengths to make this clear to the firm's executives. He constantly reminds them that forecasters need to be honest seekers of truth' if the company is to be the best it can be." He monitors the company's forecasting efforts in two ways. First, if a project's payback looks "suspiciously low," he personally investigates the forecast Second, from time to time Parker has hired outside consultants to compare the actual cash flows of a project with those predicted. And if a set of estimates looks severely optimistic," then Parker will question the forecasters, perhaps inten sively. As he puts it. "Ihad better receive satisfactory answers to my questions Executives who Parker thinks are negligent or allowing personal bus to cloud their judgment face a severe reprimand and even dismissal in one extreme case. Parker is aware that many companies are plagued by overly optimistic fore casts, and he is proud of the fact that a postaudit indicated that this has not been true for Franklin. In fact, there appears to be a tendency for the forecasts to be too conservative. That is, the postaudit showed that on average the predicted cash flows were less than the actual cash flows. REFLECTIONS Back at her apartment that evening Jones reflected on her meeting with Parker She sees "both good and not so good" with Parker's capital budgeting proce dures. Perhaps the biggest negative is the lack of any discounted cash flow tech- nique. It is clear to Jones, however, that Parker recognizes that the 20 percent target return is a book and not a market rate. It also appears that Parker is will ing to consider capital budgeting techniques based on market retums," as he puts it. Conversations with Parker suggest that a 15 percent market return PART V CAPITAL BUDGETING would be acceptable. That is Jones thinks that Parker would undertake a project if he felt that the expected return exceeded 15 percent per year. Jones is pleased at the responsibility of the assignment and is eager to make a difference. At the same time, however, she is a bit apprehensive. Jones realizes that Parker will take her report very seriously and knows that her recomenda- No SIM 3:39 PM @ 13%