When Regina McDermott opened her car repair shop in Melbourne, she thought her 15 years of experience with cars was all she would need. To a degree she was right. Within six months her shop had more work than it could handle, thanks to her widening reputation. Now two years in from start-up. Regina decided she needed to invest in new diagnostic equipment to improve efficiency within the workshop. Her accountant came to see her to discuss finance-related matters. One of these was the need for cash budgeting. 'I can work up a cash budget for you', he explained. However, I think you should understand what I'm doing so you will realise the importance of the cash budget and be able to visualise your cash inflows and outflows. I think you also need to make a decision regarding the new equipment you are planning to purchase. This machinery is state of the art, but, as we discussed last week, you can buy a number of different types of machinery. You are going to have to decide which is the best choice.' Regina explained to her accountant that she was indifferent about which equipment to buy. The choices came down to three. There was the Hobmax ProSys Diagnostic for $5935, the AutoRep AS 555003 for $4995 or the Druthers Redline X30 for $3800. 'All of this machinery is good. Perhaps I should purchase the cheapest' she reasoned. Another factor to consider was the benefit she could leverage from each machine. The Hobmax was the most expensive but offered more utility that would likely improve her throughput in the shop by 20 per cent in routine maintenance and 15 and 10 per cent respectively for small repairs and large repairs. The Autorep was an easy to use machine but without some of the bells and whistles of the Hobmax and therefore she could increase her business by as much as 25 per cent for routine repairs but maybe only 5 per cent for the small repair work and next to nothing for large repairs. The cheapest machine, the Druthers, was a specialised machine for routine maintenance only and she could see up to a 40 per cent improvement in her monthly throughput in that side of her business if she purchased this option. At this point the accountant explained to her that she could use a number of ways to evaluate this type of decision. "You can base your choice on the payback method - how long it takes to recover your investment in each of these pieces of equipment. You can base it on net present value by discounting future cash flows to the present. Or you can base it on internal rate of retum, under which the cash flows are discounted at a rate that makes the net present value of the project equal to zero.' Regina listened quietly and when the accountant was finished, she told him, 'Let me think about the various ways of evaluating my capital investment and I'll get back to you. Then, perhaps, you and I can work out the numbers together'. Her accountant said this sounded fine to him and he left. Regina began to wish she had taken more accounting courses while at university. As she explained to her husband, "When the accountant begins to talk, it's all Greek to me. But maybe 1 could at least forecast my revenue with the improved throughputs and calculate a payback period for each option.' 5 Annual Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total Regina's Auto Repairs Actual Sales Jan 2014 ($000) Routine Maintenance 4 Small Repair 3.25 Work Large Repair 2.5 Work 5 6.5 5.5 6 8 7.5 6.5 6 6.5 7.5 7 76 4.5 5.5 4.5 5 5 7 6.25 6 5.7 5.6 6 6 65.3 3 4.25 3.5 4 5 4.5 4.25 4 4.2 4.5 4 47.7 Total per 9.75 12.5 16.25 13.5 15 20 18.25 16.75 15.7 16.3 18 17 189 month QUESTIONS 1 Using the 2014 sales figures as a trend, with a spreadsheet, develop a sales forecast for January to December with the increase in workflow enabled by each machine purchasing option. Regina has calculated that she obtains a net margin of 5, 9.5 and 15 per cent respectively for the routine maintenance work, small and large repair work. Using these assumptions and assuming she buys the machine in December 2014 ready for January 2015, determine: a Which machine purchase offers the best (shortest) payback in 2015 and how many months will it take for each option? Which option will generate the greatest revenue increase in terms of dollars under the assumptions Regina has applied? c Which option provides the best forecast net percentage margin return on total revenue (net margin in dollars/total sales in dollars)? 2 How does the net present value method work? How would you explain this method to Regina? 3 How does the internal rate of return method work? How would you explain it to Regina? When Regina McDermott opened her car repair shop in Melbourne, she thought her 15 years of experience with cars was all she would need. To a degree she was right. Within six months her shop had more work than it could handle, thanks to her widening reputation. Now two years in from start-up. Regina decided she needed to invest in new diagnostic equipment to improve efficiency within the workshop. Her accountant came to see her to discuss finance-related matters. One of these was the need for cash budgeting. 'I can work up a cash budget for you', he explained. However, I think you should understand what I'm doing so you will realise the importance of the cash budget and be able to visualise your cash inflows and outflows. I think you also need to make a decision regarding the new equipment you are planning to purchase. This machinery is state of the art, but, as we discussed last week, you can buy a number of different types of machinery. You are going to have to decide which is the best choice.' Regina explained to her accountant that she was indifferent about which equipment to buy. The choices came down to three. There was the Hobmax ProSys Diagnostic for $5935, the AutoRep AS 555003 for $4995 or the Druthers Redline X30 for $3800. 'All of this machinery is good. Perhaps I should purchase the cheapest' she reasoned. Another factor to consider was the benefit she could leverage from each machine. The Hobmax was the most expensive but offered more utility that would likely improve her throughput in the shop by 20 per cent in routine maintenance and 15 and 10 per cent respectively for small repairs and large repairs. The Autorep was an easy to use machine but without some of the bells and whistles of the Hobmax and therefore she could increase her business by as much as 25 per cent for routine repairs but maybe only 5 per cent for the small repair work and next to nothing for large repairs. The cheapest machine, the Druthers, was a specialised machine for routine maintenance only and she could see up to a 40 per cent improvement in her monthly throughput in that side of her business if she purchased this option. At this point the accountant explained to her that she could use a number of ways to evaluate this type of decision. "You can base your choice on the payback method - how long it takes to recover your investment in each of these pieces of equipment. You can base it on net present value by discounting future cash flows to the present. Or you can base it on internal rate of retum, under which the cash flows are discounted at a rate that makes the net present value of the project equal to zero.' Regina listened quietly and when the accountant was finished, she told him, 'Let me think about the various ways of evaluating my capital investment and I'll get back to you. Then, perhaps, you and I can work out the numbers together'. Her accountant said this sounded fine to him and he left. Regina began to wish she had taken more accounting courses while at university. As she explained to her husband, "When the accountant begins to talk, it's all Greek to me. But maybe 1 could at least forecast my revenue with the improved throughputs and calculate a payback period for each option.' 5 Annual Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total Regina's Auto Repairs Actual Sales Jan 2014 ($000) Routine Maintenance 4 Small Repair 3.25 Work Large Repair 2.5 Work 5 6.5 5.5 6 8 7.5 6.5 6 6.5 7.5 7 76 4.5 5.5 4.5 5 5 7 6.25 6 5.7 5.6 6 6 65.3 3 4.25 3.5 4 5 4.5 4.25 4 4.2 4.5 4 47.7 Total per 9.75 12.5 16.25 13.5 15 20 18.25 16.75 15.7 16.3 18 17 189 month QUESTIONS 1 Using the 2014 sales figures as a trend, with a spreadsheet, develop a sales forecast for January to December with the increase in workflow enabled by each machine purchasing option. Regina has calculated that she obtains a net margin of 5, 9.5 and 15 per cent respectively for the routine maintenance work, small and large repair work. Using these assumptions and assuming she buys the machine in December 2014 ready for January 2015, determine: a Which machine purchase offers the best (shortest) payback in 2015 and how many months will it take for each option? Which option will generate the greatest revenue increase in terms of dollars under the assumptions Regina has applied? c Which option provides the best forecast net percentage margin return on total revenue (net margin in dollars/total sales in dollars)? 2 How does the net present value method work? How would you explain this method to Regina? 3 How does the internal rate of return method work? How would you explain it to Regina