Your task as a financial analyst is to prepare a project evaluation report for the executive committee of ABC Company, indicating whether the firm should accept or reject the new project. Your report should include the answers to the following Questions 1 to 6. It is important to list your assumptions in applying the project evaluation methods and clearly show the workings in deriving your results. Your assignment will be graded on presentation, understanding of the issues, critical analysis, logical explanation, and accuracy of calculations in solving the problems. The mark allocations for individual questions (including 20 marks for presentation, writing and professional communication) will total to 100 marks and will be scaled to produce a mark consistent with 25% weighting in the unit assessment. QUESTIONS 1. The accountants estimates in Exhibit 2 use the most likely sales projection in Exhibit 1 for each year. Are any of the 11 items listed in Exhibit 2 incorrect for application of the net present value (NPV) method? Have any relevant items been omitted from the list? Consider all information given in the case and explain why. [10 marks] 2. Prepare the incremental cash flow table (which incorporates taxes and includes initial investment, operating and terminal cash flows) for the project over the eight years based on the most likely sales projection of 1,650,000 pounds per year in Exhibit 1. Based on your estimated after-tax net cash flows, calculate the payback period, NPV, internal rate of return (IRR) and profitability index (PI) of this project. Assume ABC uses a payback rule with cut-off period of five years and the appropriate after-tax discount rate is the companys cost of capital. Should the project be undertaken based on each of the investment evaluation methods? [30 marks] 3. Undertake research to identify the qualitative factors that would affect the accept/reject decision of the project. [10 marks] 4. Show a sensitivity analysis of NPV to sales quantity (worst- and best-case scenarios) given in Exhibit 1. [10 marks] 5. Walker used a 12% discount rate to find the present value of annual cash flows caused by an increase in the unit sales of 3-in., 6-in., and 8-in. pipe. He believes this should be 13% and may be even as high as 15%. Does it make sense to use a higher discount rate in Question 2? How important is this interest rate concern to the project if the expected rate of inflation is 3% per year? Justify your answer. [10 marks] 4 6. Based on your answers to Questions 1 5 above and other information in the case, what do you recommend? Do you recommend in-house production of the 10-in. and 12-in. pipe? Defend your advice with the support of your answers. [10 marks] ****************** 5 Case in Finance ABC Pipe Company1 ABC Pipe operates on 14 acres and employed 31 people. In the fiscal year, 2008 sales totaled nearly $25 million despite the regional recession and the highly competitive nature of the piping business. The companys tax rate is 30 percent, and its weighted average cost of capital is estimated to be 10 percent. Walker, the owner of ABC pipes attributes his success to two factors: service and dedication to quality. While many firms are concerned with the quantity of pipe they produce, right from the start Walker was dedicated to manufacturing the best quality of pipe possible. If we achieve quality the quantity will take care of itself, he often tells his employees. The company also provided exceptional service. ABC Pipe keeps an unusually large volume and selection of inventory at all times and maintains a relatively large fleet of trucks. As a result, the company can fill an order quite quickly. Such fast delivery means that distributors the company sells tomany of whom are nationally known wholesalers of building materialsare able to keep their inventory low. The bulk of the firms sales comes from PVC pipe, which is mainly used in residential and commercial plumbing and government sewerage systems. This pipe comes in many different sizes, and sales depend in part on customers viewing the firm as a full-line producer. That is, a salesman is more likely to win an account if a distributor is convinced that the manufacturer can promptly deliver various sizes of the pipe as needed. This typically means that a product can quickly fill orders for the most commonly used sizes of PVC pipe; that is, pipe with diameters of 3 in., 6 in., and 8 in. Sometimes, however, a distributor is interested in 10-in. and 12-in. pipe as well. ABC has never produced these sizes internally because Walker felt that annual sales volume was too low to justify the start-up cost. If a customer does request such pipe, ABC will typically buy it from a competitor who does manufacture the desired sizes. Walker has never carefully analysed whether this is a good policy, and he thinks now is the time to do so, especially given the firms staffing situation. Walker thinks there are two main advantages to producing the 10-in. and 12-in. pipe internally. First, ABC avoids the expense of buying the pipe from another firm. ABC pays 45 cents per pound for this pipe plus another 2 cents per pound in distribution costs to get the pipe to ABCs customers. Unit selling price is 56 cents per pound. A second advantage is that the companys staffing problem would be helped. Though dollar sales have increased slightly in the last two years, the increases have not kept up with inflation. Walker realised six months ago that the firm is overstaffed by two employees. The orders simply arent there to keep all the production workers busy full time. He thinks this could continue, given not only the state of the economy but also the increase in the industry competition. 1 This case study was adapted from Case 23 by Sulock, J.M. and Dunkelberg, J.S. (1997), Cases in Financial Management, (2nd ed.). New York: John Wiley & Sons, Inc. 6 In its entire 29-year history, the firm has never been forced to even cut any workers hours, let alone lay someone off. And Walker has decided that he wont start now. If we do decide to produce the 10-in. and 12-in. pipe internally, it could solve our overstaffing problem, Walker, owner of ABC Pipe, remarked to Riggins, the plant manager. Im reluctant to lay anyone off or even cut back hours. Its not good business and its not the right thing to do if it can be at all avoided. WALKERS ESTIMATES Walker cant be certain, of course, what future sales of the 10-in. and 12-in. pipe will be. He finds it helpful to think in terms of scenarios, and has derived a set of estimates shown in Exhibit 1. These estimates are based on Walkers judgement and they reflect the firms experience with these sizes of pipe. In addition, two salespeople complained that accounts are lost when some distributors learn that ABC does not produce 10-in. and 12-in. pipe internally. Apparently, these distributors do not view ABC as a full-line producer and are concerned that ABC would not be able to fill an order as quickly as they would like. As a result, the entire account is lost and not just the orders for 10-in. and 12-in. pipe. Thus, these salesmen argue, if ABC produces the 10-in. and 12-in. internally, then new customers and new sales will result. Walker is unsure what to make of this new sales argument. If the sales personnel are correct, then ABC will more than double the figures shown in Exhibit 1 by producing the 10-in. and 12-in. in-house. Looked at from a different angle, the salesmen claim that new sales will exceed Walkers estimates, which consider only orders by existing customers. Though he can believe that new sales will be obtained, Walker finds it hard to believe that the volume is near what the salespeople claim. His first reaction is that new orders would total at least 20 and probably 50 percent of the amounts shown in Exhibit 1. EXHIBIT 1 Walkers Estimates of the Probability Distribution of Annual Sales of 10-in. and 12-in Pipe, Years 1 8* Scenario Annual Sales (000 lbs.) Probability Worst 1,350 0.1 Most Likely 1,650 0.6 Best 2,250 0.3 * These estimates do not consider the possibility that in-house production may generate new customers and new sales (see case). 7 For the time being, however, Walker decides to ignore the possibility of new sales. He wants time to investigate the claims of the sales personnel who, he believes, have a strong incentive to inflate this benefit of in-house production. He is keen to see some type of risk analysis on the project as it might be profitable, but what are the chances that it might turn out to be a loser. ABCs existing production of 3-in., 6-in. and 8-in. pipe has an average coefficient of variation of NPV in the range of 0.5 to 1.0. To adjust for differential project risk, Walker has been adding or subtracting 3 percentage points to the companys weighted average cost of capital. There is no basis for using the 3-percentage points adjustment except the subjective judgement. Therefore, perhaps the adjustment should be 2 percentage points or 5 percentage points. The most inexpensive equipment that is capable of producing the quality that Walker desires costs $1 million and can generate 3 million pounds of pipe per year. For the purpose of analysis, Walker will assume the equipment can be depreciated at 15% over eight years according to the reduced balance depreciating method. Walker expects the value of the equipment after eight years will be worth $150,000. THE ACCOUNTANTS ESTIMATES The firms accountant, Cooper, has developed a set of numbers that, in his view, strongly indicates in-house production is a losing proposition. (See Exhibit 2). Cooper estimates it will cost 54.6436 cents per pound to produce the 10-in. and 12-in. pipe internally. He notes that ABC can purchase the same pipe for 45 cents per pound from another manufacturer and incurs another 2 cents per pound to get the pipe to ABCs customers. Thus, Cooper argues, internally production results in a 7.6436 cents per pound loss, or $126,120 per year assuming 1.65 million pounds of pipe. As Walker scans these figures he smiles as he notices that Cooper used Walkers sales estimates and annual sales probabilities. He wonders, though, how accurate the accountants numbers really are. For one thing, the estimates are based on the most likely sales figure and do not consider the other sales probabilities. In addition, Walker questions the appropriateness of including depreciation, given that it is a non-cash item. For these and other reasons, he decides to rethink the figures the accountant has compiled. Walker is comfortable with a number of the items listed in Exhibit 2. He believes it is quite reasonable, for example, to assume material costs will be 33 cents per pound. However, there is no provision for increased inventories (i.e. raw materials, work-in-progress, and finished goods) requirement which is typically about 10% of annual sales. And, yes, the project would use two labourers and will require plant space and supervisory personnel. Yet the firm has significant excess space and the equipment could be operated in an unoccupied areas of the factory. In addition, Walker believes that the firms plant manager could easily supervise the project without affecting her efficiency in other areas. Walker then reflects further on his staffing situation. Although it may not be good business, he is quite comfortable with his decision not to terminate any employees. There is a high chance in each of the next three years that the two labourers used in the existing project could not be productively employed somewhere else in the firm. Walker realises that at most he will be overstaffed for three years, since two workers are scheduled to retire at that time. And there are possibilities staff would be fully utilised. If the new project is implemented, of course, new workers would have to be hired (but no new supervisors). 8 EXHIBIT 2 Accountants Estimate of Annual Cost of Producing 10-in. and 12-in. Pipe In-House 1 Raw materials $544,500 2 Distribution cost $33,000 3 Direct labour $40,000 4 Indirect labour $8,000 5 On costs $11,520 6 Utilities $8,000 7 Repairs and Maintenance $7,000 8 Space $6,600 9 General factory $18,000 10 Depreciation $125,000 11 Lost interest $100,000 TOTAL $901,620 Unit cost is 54.6436 cents = $901,620/1,650,000. Description of the above items: 1. 33 cents per pound times 1.65 million pounds per year. 2. 2 cents per pound times 1.65 million pound per year. 3. Two workers at $20,000 per year each. 4. 20 percent of item 3. This is mainly the projects share of supervisory salaries. 5. 24 percent of items 3 plus 4. This includes the firms contribution to the employees pension fund, social security, unemployment, health and disability insurance. 6. The projects share of electricity, heating, water, etc. 7. Maintenance and repair on the equipment. 8. The projects share of the factory space occupied by the equipment. 9. The projects share of items like property tax, corporate fees, secretarial support, etc. 10. Based on the average annual replacement cost of equipment over its life of 8 years: $1 million/8. 11. Lost interest on the $1 million used to purchase the equipment: 10% $1 million where 10% is the companys WACC