Kimco Ltd; Modernisation or Relocation Jereld Kim founded Kimco LTD, a firm that is currently one of the largest producers of paper and pulp with annual sales of AUD 800 million. Kim located his first plant in a rural town in Tasmania, partly to create jobs for the many unemployed workers in the area. The firm has always been active in the affairs of the community and donates generously to local civic and charitable organizations. Kimco also takes special pride in promoting a family atmosphere among its employees. Personnel experts believe that these policies are largely responsible for the enviable productivity record of Kimco's workers. During the last 50 years, Kimco had an impressive record of growth in earnings and sales. But as the company grew, the top-level management of the company was reluctant to decentralize and delegate authority to the lower business units. Randy Cole who was appointed as the CEO of the company commence to decentralize the company operation. One major change involved the company's capital budgeting procedures. Kimco didn't have a formal mechanism for capital projects. Randy appointed a six-person capital expenditures committee (CEC) that would decide projects costing more than $200,000. Smaller expenditures would be decided at the regional and local levels. At present (2022) the CEC is considering two alternatives for achieving a much-needed increase in the firm's production capacity. One option involves modernizing the existing plant in Launceston, Tasmania. If the plant is not renovated soon, production would drop to 150,000 tons per year for the next ten years. The other alternative is to build a new mill at Devonport, Tasmania. For this purpose, Kimco expects to use a land slot purchased 10 years ago for $30 million. Currently, this land has been used as a storage facility which was constructed five years ago for a cost of $5.0 million dollars. The current market value of the land is $40 million. The land value (price) of this area record 2.5% annual growth. EMPLOYEE CONCERNS Some CEC members are worried about the impact on employee morale if the factory is relocated. "Apparently," says Smith, "there is considerable opposition to closing down the old factory, judging from the inaccurate figures we received." It is noted, however, that the move will "most certainly" not cost anyone a job, but will, in fact, create new positions, including some relatively high-paying managerial ones. Nonetheless, it was obvious that the proposed relocation would impose costs on the employees. Many would either relocate to Devonport or face a 200-kilometre round trip daily commute. Smith wondered if it "was fair and appropriate" to ask the employees to bear such costs, especially considering the remarkable loyalty the Launceston employees had shown to the company. She notes that a large proportion of the employees have worked for Kimco for more than 10 years. "One thing is clear," remarks a subdued Randy. "If we choose to relocate the plant, it is important that it does not appear to be some type of ivory-tower decision that would be inconsistent with the management philosophy we promoted all these years. Smith, I am sensitive to the issues you bring up. Employee morale and employee loyalty are very important considerations. Maybe we could work something out-you know, like some type of moving allowance or separation package who do not wish to relocate." Randy also reminded the committee that Devonport was the closest suitable site to Launceston should the company move. Old plant in Launceston, Old plant in Launceston, With the reduced capacity ( 150,000 tons per year) the old machine can be used for another 10 years and sold the remaining for $5 million. If the company decide to cease the operation of the old plant, the salvage value of the old will be $25 Million at the end of year 3 . Alternative 1: Modernising the existing plant. the At beginning of the next three years (Year 0 to Year 2), the company need to spend $50 Million annually as the cost of modernisation of the existing plant. The modernisation, which expects to complete at the end of year 3, will extend the life of the old plant for another 20 years (year 4 to 23). Any expenses incurred for the modernisation can be written off during the next 20 -year period for taxation purposes. The salvage value of the modernised plant at the end of year 23 (after using 20 years) will be $5 Million. During the period of modernisation (from year 1 to year 3 ), the production level will be limited to 150,000 tons per year. It is expected the modernisation to increase the production capacity up to 300,000 tons per year from the end of year 4 to year 23 (for the next 20 years period). Modernization will help to improve labour productivity and thereby the labour cost. The annual fixed operating cost will be $9.0 million at the end of year four. The fixed operating cost will be increased by 1.4% per year. See the table given below for the other information. The figures on modernizing the existing facility at Launceston are more controversial, however. Information on this project was originally sent by the management of the Launceston plant and is also presented in the table. The controversy centres on the estimated tonnage per year of the plant and its per unit variable cost. Smith politely pointed out that it would be "extremely difficult for an old facility like the one at Launceston to achieve the output of 300,000 tons per year." In contrast to Smith's mild reaction was Randy's angry response. "You can forget it! I'll be the NBA's MVP before that plant puts out that tonnage!" Alternative 2: New plant in Devon Port. Miskin Smith, a member of the CEC, was responsible for estimating the cost and yearly cash flows from building the new paper mill at Devonport. She has provided the following estimates. The new plant aims to get the maximum possible benefits from emerging technologies. If the company proceed Alternative 2: New plant in Devon Port. Miskin Smith, a member of the CEC, was responsible for estimating the cost and yearly cash flows from building the new paper mill at Devonport. She has provided the following estimates. The new plant aims to get the maximum possible benefits from emerging technologies. If the company proceed with the new plant, the production facility in Launceston will be ceased to operate. The remaining plant will be sold at the end of year 3 when the new plant is ready for manufacturing. Any employees, who are not ready to relocate to the new plant will be compensated. It needs a $30 Million one-off payment at year 4 . It will take three years to construct the new plant. The scheduled expenses during these three years have been given in the table below. The construction cost of the new plant can be written off for the taxation during its life of 20 years starting with year 4 (Year 4 to Year 23). The salvage value of the new plant at the end of its useful life will be $75 million. The land can be sold in 20 years on the forecasted market value. or the construction has been implemented). MORE CONTROVERSY Both projects are assumed to last 20 years. This is a relatively long-time horizon for a capital budgeting project, but the company feels a paper mill is unlikely to become technologically obsolete since paper production techniques have changed very little in the last century. At least one CEC member, however, thinks that a 20-year period is too long for the "modernize-the-old" option. Past experience, he argues, indicates that revitalizing an existing facility will rarely extend its life that much, and 10 years seems more probable. If so, he wonders if "we aren't being extremely charitable to the Launceston plant. The rest of the committee concedes that 15 years may be a bit long but decides to retain this time period as a working hypothesis. 6 Use the information in the table above and the other information provided for each alternative and identify the yearly cash flow estimate for: (a) Continuing with old for 10 years (b) Modernizing the old mill. (c) Building a new mill. Capital Budgeting Evaluation (Points-10) 6 (a) Calculate the NPV of modernizing the existing paper mill. (b) Calculate the NPV of building a new paper mill. 7 (a) Calculate the IRR of each investment. (b) Calculate the payback of each. 8 (a) Do the NPV and IRR methods give the same accept/reject signals? (b) Explain why the NPV and IRR methods can give divergent signals when evaluating mutually exclusive alternatives. 9. Suppose depreciation is over 10 years instead of 20 years: (a) How would the NPV and IRR of each project be affected? Explain briefly. (b) Which of the two projects will have the larger NPV change? Why? 10 Suppose that the appropriate life of a modernized factory is 10 instead of 20 years. How it could affect the value to the business 11 Based on your calculations in the previous questions and information in the case, what decision do you recommend? Justify your choice. Scenario analysis - Calculate the NPVs for each project in each scenario (20 Points) 13 There is also some concern about the price per ton The base-case estimates assumed a price of $1,005 per ton in year 4 , but a number of managers predict $950 as the most possible price per 9. Suppose depreciation is over 10 years instead of 20 years: (a) How would the NPV and IRR of each project be affected? Explain briefly. (b) Which of the two projects will have the larger NPV change? Why? 10 Suppose that the appropriate life of a modernized factory is 10 instead of 20 years. How it could affect the value to the business 11 Based on your calculations in the previous questions and information in the case, what decision do you recommend? Justify your choice. Scenario analysis - Calculate the NPVs for each project in each scenario (20 Points) 13 There is also some concern about the price per ton The base-case estimates assumed a price of $1,005 per ton in year 4 , but a number of managers predict $950 as the most possible price per metric ton. i Calculate the NPV of each project ii Now assume if the price per ton is $1200 at the year 4 , what would be the NPV. 14 Management initially assumed a unit variable cost of $440 per metric ton. Management feels the current environmental concern on the material used for the production of paper, the variable cost per metric ton will be $480 at the year 4 . Assuming all other information is not changed, estimate the NPV. 15 Some managers believe that the output estimate in both alternatives should be less than 10% of the current estimate per year. Recalculate the NPV based on the other managers' predictions. 16 Do the results of 1315 affect your project choice in question 11? Explain. Interest Rates Interest Rates 12. Is it appropriate to use the same discount rate to evaluate both proposals? Explain your position. 17. There is some concern about the interest rates used to evaluate each project. Top management thinks that the 12 per cent rate used may be somewhat low. In addition, several managers persuasively argued that the rate used to evaluate the new facility should be a bit higher than the rate for the renovation. They argued that the new facility is of higher risk since it involves a larger sales increase. After much discussion, management decides to evaluate the projects in the following scenarios (keep all other values at their base-case estimates). Estimated the NPV under each scenario. Comment on your estimates Kimco Ltd; Modernisation or Relocation Jereld Kim founded Kimco LTD, a firm that is currently one of the largest producers of paper and pulp with annual sales of AUD 800 million. Kim located his first plant in a rural town in Tasmania, partly to create jobs for the many unemployed workers in the area. The firm has always been active in the affairs of the community and donates generously to local civic and charitable organizations. Kimco also takes special pride in promoting a family atmosphere among its employees. Personnel experts believe that these policies are largely responsible for the enviable productivity record of Kimco's workers. During the last 50 years, Kimco had an impressive record of growth in earnings and sales. But as the company grew, the top-level management of the company was reluctant to decentralize and delegate authority to the lower business units. Randy Cole who was appointed as the CEO of the company commence to decentralize the company operation. One major change involved the company's capital budgeting procedures. Kimco didn't have a formal mechanism for capital projects. Randy appointed a six-person capital expenditures committee (CEC) that would decide projects costing more than $200,000. Smaller expenditures would be decided at the regional and local levels. At present (2022) the CEC is considering two alternatives for achieving a much-needed increase in the firm's production capacity. One option involves modernizing the existing plant in Launceston, Tasmania. If the plant is not renovated soon, production would drop to 150,000 tons per year for the next ten years. The other alternative is to build a new mill at Devonport, Tasmania. For this purpose, Kimco expects to use a land slot purchased 10 years ago for $30 million. Currently, this land has been used as a storage facility which was constructed five years ago for a cost of $5.0 million dollars. The current market value of the land is $40 million. The land value (price) of this area record 2.5% annual growth. EMPLOYEE CONCERNS Some CEC members are worried about the impact on employee morale if the factory is relocated. "Apparently," says Smith, "there is considerable opposition to closing down the old factory, judging from the inaccurate figures we received." It is noted, however, that the move will "most certainly" not cost anyone a job, but will, in fact, create new positions, including some relatively high-paying managerial ones. Nonetheless, it was obvious that the proposed relocation would impose costs on the employees. Many would either relocate to Devonport or face a 200-kilometre round trip daily commute. Smith wondered if it "was fair and appropriate" to ask the employees to bear such costs, especially considering the remarkable loyalty the Launceston employees had shown to the company. She notes that a large proportion of the employees have worked for Kimco for more than 10 years. "One thing is clear," remarks a subdued Randy. "If we choose to relocate the plant, it is important that it does not appear to be some type of ivory-tower decision that would be inconsistent with the management philosophy we promoted all these years. Smith, I am sensitive to the issues you bring up. Employee morale and employee loyalty are very important considerations. Maybe we could work something out-you know, like some type of moving allowance or separation package who do not wish to relocate." Randy also reminded the committee that Devonport was the closest suitable site to Launceston should the company move. Old plant in Launceston, Old plant in Launceston, With the reduced capacity ( 150,000 tons per year) the old machine can be used for another 10 years and sold the remaining for $5 million. If the company decide to cease the operation of the old plant, the salvage value of the old will be $25 Million at the end of year 3 . Alternative 1: Modernising the existing plant. the At beginning of the next three years (Year 0 to Year 2), the company need to spend $50 Million annually as the cost of modernisation of the existing plant. The modernisation, which expects to complete at the end of year 3, will extend the life of the old plant for another 20 years (year 4 to 23). Any expenses incurred for the modernisation can be written off during the next 20 -year period for taxation purposes. The salvage value of the modernised plant at the end of year 23 (after using 20 years) will be $5 Million. During the period of modernisation (from year 1 to year 3 ), the production level will be limited to 150,000 tons per year. It is expected the modernisation to increase the production capacity up to 300,000 tons per year from the end of year 4 to year 23 (for the next 20 years period). Modernization will help to improve labour productivity and thereby the labour cost. The annual fixed operating cost will be $9.0 million at the end of year four. The fixed operating cost will be increased by 1.4% per year. See the table given below for the other information. The figures on modernizing the existing facility at Launceston are more controversial, however. Information on this project was originally sent by the management of the Launceston plant and is also presented in the table. The controversy centres on the estimated tonnage per year of the plant and its per unit variable cost. Smith politely pointed out that it would be "extremely difficult for an old facility like the one at Launceston to achieve the output of 300,000 tons per year." In contrast to Smith's mild reaction was Randy's angry response. "You can forget it! I'll be the NBA's MVP before that plant puts out that tonnage!" Alternative 2: New plant in Devon Port. Miskin Smith, a member of the CEC, was responsible for estimating the cost and yearly cash flows from building the new paper mill at Devonport. She has provided the following estimates. The new plant aims to get the maximum possible benefits from emerging technologies. If the company proceed Alternative 2: New plant in Devon Port. Miskin Smith, a member of the CEC, was responsible for estimating the cost and yearly cash flows from building the new paper mill at Devonport. She has provided the following estimates. The new plant aims to get the maximum possible benefits from emerging technologies. If the company proceed with the new plant, the production facility in Launceston will be ceased to operate. The remaining plant will be sold at the end of year 3 when the new plant is ready for manufacturing. Any employees, who are not ready to relocate to the new plant will be compensated. It needs a $30 Million one-off payment at year 4 . It will take three years to construct the new plant. The scheduled expenses during these three years have been given in the table below. The construction cost of the new plant can be written off for the taxation during its life of 20 years starting with year 4 (Year 4 to Year 23). The salvage value of the new plant at the end of its useful life will be $75 million. The land can be sold in 20 years on the forecasted market value. or the construction has been implemented). MORE CONTROVERSY Both projects are assumed to last 20 years. This is a relatively long-time horizon for a capital budgeting project, but the company feels a paper mill is unlikely to become technologically obsolete since paper production techniques have changed very little in the last century. At least one CEC member, however, thinks that a 20-year period is too long for the "modernize-the-old" option. Past experience, he argues, indicates that revitalizing an existing facility will rarely extend its life that much, and 10 years seems more probable. If so, he wonders if "we aren't being extremely charitable to the Launceston plant. The rest of the committee concedes that 15 years may be a bit long but decides to retain this time period as a working hypothesis. 6 Use the information in the table above and the other information provided for each alternative and identify the yearly cash flow estimate for: (a) Continuing with old for 10 years (b) Modernizing the old mill. (c) Building a new mill. Capital Budgeting Evaluation (Points-10) 6 (a) Calculate the NPV of modernizing the existing paper mill. (b) Calculate the NPV of building a new paper mill. 7 (a) Calculate the IRR of each investment. (b) Calculate the payback of each. 8 (a) Do the NPV and IRR methods give the same accept/reject signals? (b) Explain why the NPV and IRR methods can give divergent signals when evaluating mutually exclusive alternatives. 9. Suppose depreciation is over 10 years instead of 20 years: (a) How would the NPV and IRR of each project be affected? Explain briefly. (b) Which of the two projects will have the larger NPV change? Why? 10 Suppose that the appropriate life of a modernized factory is 10 instead of 20 years. How it could affect the value to the business 11 Based on your calculations in the previous questions and information in the case, what decision do you recommend? Justify your choice. Scenario analysis - Calculate the NPVs for each project in each scenario (20 Points) 13 There is also some concern about the price per ton The base-case estimates assumed a price of $1,005 per ton in year 4 , but a number of managers predict $950 as the most possible price per 9. Suppose depreciation is over 10 years instead of 20 years: (a) How would the NPV and IRR of each project be affected? Explain briefly. (b) Which of the two projects will have the larger NPV change? Why? 10 Suppose that the appropriate life of a modernized factory is 10 instead of 20 years. How it could affect the value to the business 11 Based on your calculations in the previous questions and information in the case, what decision do you recommend? Justify your choice. Scenario analysis - Calculate the NPVs for each project in each scenario (20 Points) 13 There is also some concern about the price per ton The base-case estimates assumed a price of $1,005 per ton in year 4 , but a number of managers predict $950 as the most possible price per metric ton. i Calculate the NPV of each project ii Now assume if the price per ton is $1200 at the year 4 , what would be the NPV. 14 Management initially assumed a unit variable cost of $440 per metric ton. Management feels the current environmental concern on the material used for the production of paper, the variable cost per metric ton will be $480 at the year 4 . Assuming all other information is not changed, estimate the NPV. 15 Some managers believe that the output estimate in both alternatives should be less than 10% of the current estimate per year. Recalculate the NPV based on the other managers' predictions. 16 Do the results of 1315 affect your project choice in question 11? Explain. Interest Rates Interest Rates 12. Is it appropriate to use the same discount rate to evaluate both proposals? Explain your position. 17. There is some concern about the interest rates used to evaluate each project. Top management thinks that the 12 per cent rate used may be somewhat low. In addition, several managers persuasively argued that the rate used to evaluate the new facility should be a bit higher than the rate for the renovation. They argued that the new facility is of higher risk since it involves a larger sales increase. After much discussion, management decides to evaluate the projects in the following scenarios (keep all other values at their base-case estimates). Estimated the NPV under each scenario. Comment on your estimates