MAGIC TIMBER AND STEEL PTY. LTD.

Magic's original owners, John Davidson and Kelly Peters, leased the company's first premises on the site of a disused service station, and specialized in packs of "seconds" timber that was sold to the retail market at discounted prices. The business was successful and eventually outgrew the small premises.

In July 2002, Magic purchased an industrial block of land that was approximately 10 times the size of the leased premises and on which was built a large, secure shed. The owners decided to move on from the timber packs and instead set up the new location as a timber yard. As the business continued to grow, Davidson and Peters began stocking hardware supplies and purchased a large Scania truck that could be used for picking up products and providing delivery service. Magic also invested in a range of machinery.

While the owners were happy to pay out a large sum of money for a new Scania, they decided to purchase onlysecondhandmachinery.Asthebusinessgrew,theypreferredtolimitthestafftothemselves,oneother permanentemployee,andtwocasualemployeeswhowouldworkonanon-callbasis,asdemandrequired.

For Magic, the timing of its growth was fortuitous because the Sunshine Coast was undergoing a rapid residentialbuildingexpansioninresponsetoa10percentperannumpopulationgrowthin2002,2003,and 2004.²Duringthisgrowthphaseforthecompany,Magicearnedareputationforbeingasupplierofdiscount products, and soon, the company had acquired a substantial core of builders as its customers. The smaller retailmarketcontinuedtogrow,butproportionallybecamealowercontributortoMagic'ssalesactivity.In 2005, Davidson bought Peters' share of the company and became the sole shareholder. As part of the agreement, Peters kept the Scania truck, along with the debt associated withit.

Around 2011, Magic's business peaked in terms of sales revenue and then experienced a steady decrease in turnover (see Exhibit 1).³This decline was attributed to a number of reasons, including infrastructure issues on the coast, a slowdown in the tourism industry, and a decrease in population growth (less than 4 per cent in 2011); however, the Sunshine Coast still remained one of Australia's fastest-growing regions. As a result of the declining economic environment, a number of builders who held accounts with Magic went into liquidation, leaving the company with bad debts that had to be written off or placed on payment plans, a situation that had a significant impact on Magic's own financial situation. Around the same time, alargeAustralianpubliclylistedretailer,WesfarmersLimited,openedoneofitslargeBunningsWarehouse Stores (Bunnings) within two kilometres of Magic's premises. Bunnings was similar to North America's Home Depot, and was a direct competitor toMagic.

During 2013 and 2014, in an effort to reinvigorate Magic, Davidson undertook an increased marketing campaignthatincludedprintandradio.HealsoaddedsteeltoMagic'sproductline,whichnecessitatedthe purchase of a large laser cutting machine that required a significant capital outlay of $300,000.⁴Davidson continuedtopromotehisbusinessasdistinguishingitselffromthelargercompetitorsbyprovidingpersonal service, and he strived to give an impression of a successful, professionalbusiness.

While a number of similar-sized competitors left the market, thanks to Davidson's experience and the company's significant stock holding, Magic was able to stay solvent. Subsequently, as business became moredifficult,DavidsonactivelysoughttoreduceMagic'sstocklevels,replacingthemonlyasthemarket demanded rather than holding a diverse range. Not surprisingly, this approach to inventory control meant thatsomecustomersshoppedelsewheresinceMagicdidnotstockwhattheyneededtopurchase.Davidson accepted this reality and continued with his strategy of stocking core items at good prices and offering expert, friendlyassistance.

THE ISSUE

While the move into the steel business had proved relatively successful due to Magic's state-of-the-art machinery, the older timber equipment was showing its age and becoming more troublesome ? in particular, the large finisher. A report offered by the machine's manufacturer suggested that the machine could be reinvigorated; however, Davidson wondered whether the company should instead invest in anew machine that would offer increased capability and reduced maintenance. Davidson believed this new machinewouldturnMagic'sfortunesaroundandreturnittotherevenuelevelsachievedanumberofyears

2"Sunshine Coast, State of the Region 2013," Regional Development Australia, accessed August 4, 2015,www.rdasunshinecoast.org.au.

3Davidson had forecast future revenues and profits based on the trend of the recent years, and he predicted that net profit would fall below his acceptable minimum amount of $200,000 in 2017.

4All currency amounts are in AU$ unless otherwise stated.

ago. The new machine required a significant outlay, however, and it was this investment decision that Davidson had to consider.

Existing Machine

TheexistingmachinewasaMatrix750.TheMatrixhadbeenpurchasedsecondhandwhenitwasfiveyears old. Davidson was particularly concerned with staff safety and was reluctant to allow other staff members tousethismachinebecausethisparticularmodelwasknowntobeverysensitivetotheangleofthetimber and would kick back severely if the lumber was not correctly positioned. Davidson had not experienced this particular problem since owning themachine.

Acompetitorhadoffered$35,000cashforthemachine,anamountthatrepresenteditscurrentbookvalue. IfDavidsonoptedtokeepthemachine,Magicwouldcontinuetoclaimdepreciationof$6,000peryearfor eachofthenextfiveyears,atwhichpointthemachinewouldbeunserviceableandwouldbesoldfor$5,000 as scrap. If Davidson elected to keep and repair the old machine, it would require $28,000 to be spent immediatelyand$7,000inregularmaintenanceineachofthenextfiveyears.InYear3,themachinewould require another investment of $4,000 for a larger scheduledservice.

New Machine

The new machine under consideration was a Delta A390, which offered an increase in capacity of 40 per cent. This capacity was probably in excess of Magic's needs, although the business would make some use of it. Also, the new machine allowed the possibility of obtaining some custom work for a specialist woodcrafter.

The new machine cost $140,000, and the tax office allowed straight line depreciation of 10 per cent per annum. After five years, Magic would sell the Delta for $60,000. Given that the company selling the machine to Magic operated in a very competitive market, it was willing to negotiate on the terms of a maintenance plan. The seller offered fixed pricing starting at $2,000 in the first year, increasing by $1,000 per year (payable at year end). To fund the purchase, Magic's bank offered a 6 per cent per annum loan to be repaid as interest-only payments for five years, with the full principal repayable at the end of the loan period.

Given the technological advancements of the Delta over the Matrix, Davidson expected that he could achieve significant savings in both labour and electricity costs. For labour, in the first year, Davidson forecasted a 10 per cent cost reduction (the existing rate was $30 per hour), based on a 35-hour week in a 50-week year. This labour saving would then increase by a fixed $250 each year.

For electricity, in the first year, the saving was expected to be 10 per cent as well. Electricity costs averaged

$5.625 per hour, 24 hours a day, seven days a week, in a 50-week year. This electricity saving would then increase by a fixed $75 each year.

THE DECISION

While Davidson felt enthusiastic about the upcoming possibilities for Magic, he had some concerns about thenewlevelofdebt,notjustregardingthesizeoftheloan,butalsowithrespecttowhatthatcommitment meant for the business in terms of future opportunities. Davidson believed that if new business arose as a resultoftheincreasedcapacity,thedebtrepaymentscouldbecomfortablymet?butthemarketconditions and the competitive nature of Bunnings concerned him. However, he also realized that if he opted to do nothing, the company's declining revenue trend of the last few years would most likely continue. Should Magic go ahead with the investment in the newmachinery?

EXHIBIT 1: MAGIC REVENUE AND NET PROFIT

Actual Revenue and Net Profit for Magic (in dollars): 2009-2015

2009:

-Revenue: 800 000

-Net Profit: 350 000

2010:

-Revenue: 880 500

-Net Profit: 400 000

2011:

-Revenue: 945 000

-Net Profit: 460 000

2012:

-Revenue: 865 000

-Net Profit: 390 000

2013:

-Revenue: 820 750

-Net Profit: 365 000

2014:

-Revenue: 780 000

-Net Profit: 325 000

2015:

-Revenue: 730 000

-Net Profit: 290 000

Forecast Revenue and Net Profit for Magic: 2016-2018

2016:

-Revenue: 680 000

-Net Profit: 250 000

2017:

-Revenue: 630 000

-Net Profit: 190 000

2018:

-Revenue: 550 000

-Net Profit: 140 000

Question:

Using an NPV analysis, advise Davidson as to whether or not Magic should purchase the new

Delta finishing machine. The company tax rate applicable to Magic is 30%.Assume the cost of capital is 11%.

Please put all of the details (See the picture).

A B C D E F G NPV of purchasing DELTA Calculation of Tax 0 1 2 3 4 UI Repair costs saved (old) Maintenance saved (old) Major service saved (old) Labour saving (new) Electricity saving (new) Maintenance (new) Depreciation foregone (old) Depreciation (new Profit Loss on sale (new) Taxable Income Tax payable (saving) Cash Flows Sale of MATRIX Cost of DELTA Scrap foregone (old) Repair costs saved (old) Maintenance saved (old) Major service saved (old) Scrap (new) Labour saving (new) Electricity saving (new) Maintenance (new) LESS Tax CASH FLOWS Discount factors at cost of capital Discounted Cash Flows (DCF) Net Present Value