This case examines capital budgeting issues related to the construction and operation of a marina. The case requires students to identify the relevant cash ?ows and discount these to establish a net present value (NPV) for the investment. Issues addressed through the case include incorporating in?ation into cash ?ows and the choice of appropriate discount factors; i.e., nominal and real, tax issues relating to the treatment of cash and non-cash items, the determination of terminal values, and the impact of depreciation on after-tax cash ?ows. The case extends beyond a simple calculation of NPV to the derivation of an appropriate breakeven rental in the ?rst year of operations.

Case Background

Jim was excited as he drove into the car park at Floating Investments Limited. The senior management meeting was scheduled for 9 AM and his proposal was the major item on the agenda. Jims o?cial title was Projects Manager and he was responsible for initiating and overseeing new projects. This particular project was close to Jims heart because it involved sailingan activity that Jim had spent many years pursuing both socially and competitively. Jim believed that his project was well suited to Floating Investments as it was an extension of existing business.

Floating Investments Limited specializes in marine investment projects. Projects previously undertaken by the company include construction of canals and moorings for a major residential development and redevelopment of Fishermans Wharf in the downtown area. Given the nature of these projects, including the length of time over which the initial investments were recovered, the degree of risk involved was generally higher than more traditional investment projects.

Although Jim had completed a business degree at University, he was determined that his accounting background would not overshadow his career choice as an operational manager. Last night he had told his wife: This project sells itself. The idea is good. I know the sailing world and weve got the big picture sorted out. Newland Harbor has only one marina to serve over 6000 boats, 80% of which cannot get marina berths and use moorings that sailors must row to. Weve already got the site and the contractor lined up to build a new marina. All we need is managements go ahead. The accountants can sort out the dollars and cents later.

The Chief Executive O?cer (CEO) opened the meeting and after the preliminaries gave Jim the signal to present his proposal. Jim knew the CEO was an experienced yachtsman and was con?dent that he would support the project. He started his proposal by describing the current shortage of marina berths and the size of the market, emphasizing that the local Port Authority owned the only existing marina. Because the Authority charged only a minimal rental, anyone who possessed a berth generally kept it and there was an elaborate (and lucrative) black market in trading the license to those on the waiting list.

Jim continued, The proposed marina is designed for 500 boats and we estimate that it will take two years to build commencing 1st November, 2014. Because of the shortage of marina berths it is expected that all berths will be leased from 1st November, 2016. The 50-acre site we intend using for the project was purchased several years ago for $268,000 as part of the Fishermans Wharf development, although it was never used for that project.

Construction of the marina falls into three stages:

1. Construction of sea walls, dredging the seabed, excavations for marina o?ces and service facilities, and road access.

2. Inserting piles and assembling pontoons.

3. Constructing buildings and facilities such as marina o?ce, chandlery, repair workshops, and waste disposal.

The most favorable tender, from a reputable construction company, indicates a total construction cost of $12,000,000 payable as follows:

10% payable prior to commencement (31st October, 2014)

40% payable one year later

40% payable on completion (31st October, 2016)

10% retention payable one year after completion

There will be three categories of berths:

Category A for boats between 12 and 18 meters in length: 50 berths

Category B for boats between 8 and 12 meters in length: 300 berths

Category C for boats between 6 and 8 meters in length: 150 berths

I am sure you will agree that this is an excellent project and an exciting opportunity for the company.

Jim sat down. The CEO spoke: That site you had in mind. Weve just had an o?er from a real estate developer of $7000 per acre. How does that a?ect your project? Peter Shrivers from marketing also asked: How much are you going to charge for the berths? I know that the Port Authority charges $4500 for my 10-meter ketch. How does this compare? And what is the bottom line on this?

Jim was silent. He hadnt thought that management would want the ?nancial details so soon. Help came from an unexpected quarter. Emma Nautically, the Financial Controller spoke: Figuring out a price is not going to be easy because there has not been a proper market for marina berths in Newland before. A sensible ?rst step would be to calculate the minimum rental for the project to break even. At the same time we can commission a market survey to ?nd out what price boat owners will be prepared to pay for the berths. We also need to consider other issues such as tax e?ects, in?ation, and the opportunity cost of funds. Why dont Jim and I sit down and sort out a formal ?nancial analysis and present it at the next management meeting this time next month?

To Jims great relief, the meeting agreed to Emmas suggestion. He was o? the hook, at least for the moment. After the meeting had ended, he thanked Emma. She laughed: It always pays to buy some time particularly when its a big project. You had the big picture okay but at the end of the day, the ?nancials have got to be sorted out. I know you majored in management accounting at University so you can probably remember how to do this type of analysis. Let me give you some further information. Jim started taking notes.

Emma continued: The tax rate is 50% and 4% depreciation on a straight-line basis will be allowed for 80% of the construction cost. The companys cost of capital is 16.6% after allowing for tax and in?ation. Based on current needs and past experience, 16.6% should cover the required rate of return to shareholders, debt repayment, and include a factor for the risk involved in this type of investment. Lets assume that cash ?ows take place at the end of each year. What about operating costs and working capital?

Jim replied: I estimated that the lease rentals, maintenance and supervisory costs and land values will rise in line with in?ation, which is expected to be 6% annually over the life of the marina. Annual maintenance and supervisory costs are estimated to be $60,000 at current prices. Working capital requirements are not expected to be signi?cant.

Emma asked: What will the time horizon be? We will need to think about terminal values as they can often determine the success or otherwise of a project.

Jim considered her question: We intend that the lease periods for each berth will be for a twenty-year period; in other words, the period from 1st November, 2016 to 31st October, 2036. Its probably safest to assume initially that the land will be the only valuable asset at the end of 2036.

Emma gave Jims reply some thought and then said, Okay, I think that we have enough information now to do the analysis. There are two things we need to do. First, we have to calculate the amount of annual, pre-tax lease rental that must be generated in order for the project to break even. Calculate this amount for the ?rst year of operations.

Second, using this ?rst-year amount, calculate how much an owner of a 10-metre yacht will pay in the ?rst year. We can then compare this with the amount Peter Shrivers pays. I guess a simple way of doing this is to use the mid-points of the size ranges to calculate the total meters.

Jim returned home that evening. How did it go? asked his wife. Jim confessed: I think I would have been out of a job if it hadnt been for the accountants. Have you seen my old management accounting books? Im going to need them.

You are required to:

Identify the information that Jim needs to present to the Board at the next meeting, providing calculations using the data supplied. Set out all the assumptions that need to be made and examine their reasonableness and consequences if violated.

Include in your information set an analysis of the risks inherent in this type of investment and discuss the ways in which management of these risk factors can be incorporated in the project.

Mr. Action, the Corporate Controller at Kantanka Plant in Ghana, having heard his lecturer: Dr. Agyenim-Boateng speak on some of the shortcomings of current cost accounting systems, decided to undertake a review of the cost accounting system at his Kantanka Plant. He was particularly concerned whether the overhead costs were being allocated to products according to the resource demands of the products. Costing our products accurately has become more important for strategic purposes because of pressures to unbundle sets of original equipment windows for the automakers.

Kantanka Plant (KP), one of the companies in the Kantanka Group, has been a major producer of glass in Ghana since 2000. Its Kantanka Plant produces about 12 million lites of tempered glass per year. A lite is a unit such as a rear window, which is called a back lite, or a side window, which is called a side lite.. The plant makes front door windows, quarter windows, back windows, and sunroofs. About 96 percent of the lites produced are sold to automotive customers; the remaining 4 percent are shipped to replacement depots for later sale to replacement glass wholesalers. Lite sizes range from .73 square feet for certain quarter windows to about 13 square feet for the back lite of a Camaro/Firebird. The average size is approximately four square feet.

The Kantanka Plant is comprised of two production processes: float and fabrication (fab). The float process produces raw float glass, the raw material for automotive windows. Blocks of float glass are transferred to the fab facility, where lites are cut to size, edged, shaped, and strengthened. The final product is then inspected, packed, and shipped. Parts of the Kantanka Plant date to the founding of the company. Unlike other Kantanka plants, which were designed around the automated Kantanka float-tank process with computer controlled cutting and finishing operations, the Kantanka Plant was designed for the older process of polishing plate glass to final products. Kantanka float-tanks were installed in the plant during the 2000s, and the cutting processes were substantially automated during 2010. However, the finishing processes have not yet been automated to the extent as at the other plants.

Mr. Action, Corporate Controller of Kantanka, and Mr. Slow, Kantankas Plant Controller, became concerned during 2015 about the cost allocation process at Kantanka Plant for several reasons. First, the process had not been critically evaluated since the automation of the cutting processes. Second, the overhead cost structure at Kantanka Plant differed dramatically from that of other Kantanka Group Plants. A larger pool of indirect costs was allocated to equipment centers. Third, they had collected evidence that the cost allocation process at Kantanka Plant was not accurately assigning costs to units of product. And fourth, changes in the companys competitive environment were raising strategic issues that demanded accurate product cost information for pricing, product mix, and production scheduling purposes.

In his investigation, Mr. Action, discovered what he believed were two key observations made by the Vice Presidents of Engineering and Manufacturing. Historically in the automotive glass business, original equipment customers have purchased a complete set of windows for a car model from a single glass manufacturer. From the glass manufacturers perspective it was therefore necessary that the markup on cost for the entire set, or bundle, of glass units be adequate for profitability. Despite the buying habits of these automotive customers, firms in the industry quoted selling prices for individual units of glass within each set. As easy benchmarks, the selling prices were customarily set in proportion to the size in square feet of the units, with smaller lites priced lower than larger lites. However, the cost of producing automotive glass is not related proportionately to the size of the unit produced. The production process involves two principal fabricating operations: cutting the unit from a larger block of glass, and then bending it to the necessary shape and strengthening it in a tempering furnace. Neither the cost of cutting nor the cost of tempering is proportional to the size of the unit produced. Only a limited number of units can be fed into either a cutting machine or a tempering furnace regardless of the size of the units, with little or no difference in feed rates or resource consumption related to size.

The joint effect of these two observations is an understanding in the glass industry of the average relationship between unit size and unit profit. Margin percentages for passenger car lites are somewhat higher than the industry average.

Recent changes in the competitive structure of the automotive glass industry have led to the possibility of unbundling sets of windows. Major customers are considering not only allowing different manufacturers to supply units for the same car model (for example, windshields from one and rear windows from another) but also setting target prices based on the manufacturing costs of the units, a process already begun by other automotive manufacturing companies. Under these circumstances, the costs reported by the accounting system for individual units of glass have strategic implications that were not relevant in the past.

Required:

What is the cost object before the change in the product costing system? After the change? Why did Mr. Action and Mr. Slow change the focus of the system?

What are the characteristics of a good product costing system?

How do the process control and product costing functions of Kantanka Plants cost accounting system interact? What conversion costs are treated as direct product costs in the system?

In your opinion, is the new allocation method for general plant costs better than the old method? Why or why not?