THE COMPANYMagic Timber and Steel $($Magic$)$ was

formed in $1999$ in Caloundra on the Queensland Sunshine Coast,

Australia. $1$ Located about $100$ kilometres $(60$ miles$)$ north of the

state capital of Brisbane, the coast was known for its clean,

protected beaches and safe waters. The business peaked in terms of

sales revenue in about $2011,$ and went on to experience a steady

decrease in turnover that was attributed to a number of reasons,

including infrastructure issues on the coast and a slowing in the

tourism market. To reinvigorate the business, in early $2015,$

Magic$$s owner, John Davidson, believed his company required an

investment in fixed assets, specifically, a large finisher that

would increase capacity and reduce maintenance. Since the new

machine required a large financial investment, Davidson used the

net present value method to determine whether the purchase would

add value to the firm. In addition, he needed to consider some

important qualitative factors before a decision could be made.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 machineryWhile the owners were happy to pay out

a large sum of money for a new Scania, they decided to purchase

only secondhand machinery. As the business grew, they preferred to

limit the staff to themselves, one other permanent employee, and

two casual employees who would work on an on$-$call basis, as demand

required. For Magic, the timing of its growth was fortuitous

because the Sunshine Coast was undergoing a rapid residential

building expansion in response to a $10$ per cent per annum

population growth in $2002,2003,$ and $2004\mathrm{.}2$ During this growth

phase for the company, Magic earned a reputation for being a

supplier of discount products, and soon, the company had acquired a

substantial core of builders as its customers. The smaller retail

market continued to grow, but proportionally became a lower

contributor to Magic$$s sales activity. 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 with it$.$ Around $2011,$ Magic$$s business peaked in

terms of sales revenue and then experienced a steady decrease in

turnover $($see Exhibit $1)\mathrm{.}3$ This 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, a large Australian

publicly listed retailer, Wesfarmers Limited, opened one of its

large Bunnings Warehouse Stores $($Bunnings$)$ within two kilometres of

Magic$$s premises. Bunnings was similar to North America$$s Home

Depot, and was a direct competitor to Magic. During $2013$ and $2014,$

in an effort to reinvigorate Magic, Davidson undertook an increased

marketing campaign that included print and radio. He also added

steel to Magic$$s product line, which necessitated the purchase of a

large laser cutting machine that required a significant capital

outlay of $$300,000\mathrm{.}4$ Davidson continued to promote his business as

distinguishing itself from the larger competitors by providing

personal service, and he strived to give an impression of a

successful, professional business. 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 more difficult, Davidson

actively sought to reduce Magic$$s stock levels, replacing them only

as the market demanded rather than holding a diverse range. Not

surprisingly, this approach to inventory control meant that some

customers shopped elsewhere since Magic did not stock what they

needed to purchase. Davidson accepted this reality and continued

with his strategy of stocking core items at good prices and

offering expert, friendly assistanceTHE ISSUEWhile 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 a new machine that would offer

increased capability and reduced maintenance. Davidson believed

this new machine would turn Magic$$s fortunes around and return it

to the revenue levels achieved a number of years ago. The new

machine required a significant outlay, however, and it was this

investment decision that Davidson had to consider.Existing MachineThe existing machine was a Matrix $750.$

The Matrix had been purchased secondhand when it was five years

old. Davidson was particularly concerned with staff safety and was

reluctant to allow other staff members to use this machine because

this particular model was known to be very sensitive to the angle

of the timber and would kick back severely if the lumber was not

correctly positioned. Davidson had not experienced this particular

problem since owning the machine. A competitor had offered $$35,000$

cash for the machine, an amount that represented its current book

value. If Davidson opted to keep the machine, Magic would continue

to claim depreciation of $$6,000$ per year for each of the next five

years, at which point the machine would be unserviceable and would

be sold for $$5,000$ as scrap. If Davidson elected to keep and repair

the old machine, it would require $$28,000$ to be spent immediately

and $$7,000$ in regular maintenance in each of the next five years.

In Year $3,$ the machine would require another investment of $$4,000$

for a larger scheduled service.New MachineThe new machine under consideration

was a Delta A$390,$ 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\mathrm{.}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 DECISIONWhile Davidson felt enthusiastic about

the upcoming possibilities for Magic, he had some concerns about

the new level of debt, not just regarding the size of the loan, but

also with respect to what that commitment meant for the business in

terms of future opportunities. Davidson believed that if new

business arose as a result of the increased capacity, the debt

repayments could be comfortably met $$ but the market conditions 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 new machinery?$$Update: The cost of

new machine Delta is $130,000$ instead of $140,000$ given in the

case.$*$ Using NPV analysis, should Magic

Timber and Steel $($Magic$)$ purchase the new Delta finishing

machine?$$ What other quantitative and$/$or

qualitative factors $($see below$)$ need to be taken into

consideration?$$ Sensitivity analysis $($e$.$g$.,$

different discount rates, different selling prices, change in

maintenance cost$)$ You may assume discount rate as $12\%$

and tax rate as $30\%.$Cash Flows:Matrix:$$ Salvage value, Repair, Maintenance,

Scheduled service,Machine Sales

Delta:$$ Machine investment, Labour savings,

Electricity savings, Maintenance, Salvage value, Profit$/$Loss from

saleNon$-$Cash Flows:Matrix:$$ Depreciation $($given in case$)$Delta:$$ Depreciation $(10\%$ per year of cost

$$130,000)$Tax Impact relevant Cash

Flows:Which of the above cash flows and

non$-$cash flows could impact the cash flow for tax

saving$/$payment$?$ Savings $(+$ taxable income$),$ Costs $(-$

taxable income$),$ Depreciation $($Matrix$,$ Delta$),$ Profit$/$Loss from

SaleCash Flows for

NPV:Which of the above cash flows

$($including tax impact relevant cash flows$)$ are relevant for

purchase of Delta decision?