Capital Budgeting Methods and Cash Essay
Capital Budgeting Methods and Cash
In the early 1990s, the farm economy in the heartland of the United States was weak. Farmers in North Dakota produced hard, amber Durham wheat and exported 75% to Italy for the production of high quality pasta. Prices for raw wheat fluctuated radically, depending on weather and growing conditions. Many farmers were having difficulty meeting payments for the expensive farm machin- ery required for crop production. Small family farms were disappearing and non-farm jobs in the area were scarce. Although consumers were paying record prices for food, many farmers felt that processors, who converted the raw grains into finished products for sale in grocery stores, were generating large profits. Jim Strongbeard, one of North Dakota’s largest wheat growers, read an article about a suc- cessful Nebraska pasta plant. It was established and operated by the local growers in order to process their wheat into consumer products. The winter had already been long, and Jim decided to visit his sister who lived near the plant.
While there, he arranged to meet with company executives and the production manager to see if a similar plant could operate in the rural Dakotas. His visit was extremely fruitful. Not only did he determine that a pasta operation could be profitable, but Steve Hildeman, the plant manager and a North Dakota native, expressed an interest in establishing a new plant. Jim returned home and started talking to other growers. The farmers were convinced that vertical integration, combining the production and processing of their wheat, would help them gain control over their product and also help with diversification. In 1993, Prairie Winds Co-op was formed, and 1,000 Durham wheat growers in North Dakota and Canada purchased shares. They pledged a specific amount of wheat, at a set price, for the production of pasta.
If the wheat market is weak, farmers have an outlet for their crops. When the market for pasta is strong, farmers make money on the guaranteed sale of wheat as well as a profit on the finished product. The co-op hired Steve Hildeman to get the effort operational, and in 1994 Prairie Winds Pasta opened a $55 million production facility in the middle of the wheat fields. The facility was located on two rail lines and had decent highway access for distribution. The co-op bought state- of-the-art pasta production equipment from the manufacturer in Italy and arranged for the best arti- san in the industry to get the equipment in place and running. The equipment contained huge brass wheels with dies for cutting the pasta. It had two high-speed, long-cut lines for producing items such as fettuccine, linguini, and a variety of spaghetti and two short-cut lines for smaller items such as elbows, shells, ziti, and penne. The plant made 30 different items (or cuts), although 50 percent of the business was from ziti, thins, spaghetti, and elbows. The co-op produced the pasta for a variety of retail grocery stores, and packaged it under the customers’ store labels.
The plant was not expected to make a profit for three years due to high start-up costs. However at the end of the first year, the plant had made a profit of $1 million. The operation provided 135 new relatively high-paying jobs in the community, and the local economy was strong. While variable cost of production was 26 cents per pound, wholesale price was 37 cents per pound delivered, and the pasta generally retailed for 59 cents per pound. Total fixed operating costs for the company currently is $2.3 million. After two years of production, the company was shipping the bulk of the retail product to the northeastern United States.
Also, the co-op expanded the customer base to include the government, restaurants, and food service operations. The phenomenal success of the product required the machinery to operate 24 hours a day. Annual output jumped to 140 million pounds of pasta, and the plant was running at capacity. The high demand for the company products resulted in difficulty filling orders for its cus- tomers. Because of the rapid inventory turnover in the retail grocery trade, customers demand delivery within one week with a maximum allowance of 10 days. It generally takes four to five days lead time for Prairie Winds Pasta to put a specific product into production and an average of 4 days to ship the product to the customer. The 30 different varieties of pasta and rapid inventory turnover resulted in high levels of non-production time required to switch production from one type of pasta to another. Prairie Winds was experiencing difficulties satisfying existing customers on a timely basis. Several of the large grocery store chains had indicated that they might switch sup- pliers if they could not get a reliable shipment of goods.
To help mitigate the immediate supply crisis, Steve arranged for the Italian machinery tech- nicians to fine-tune the existing machines and increase capacity by 10 percent. However, Steve was not sure how long the equipment would be able to operate under this type of production schedule. Steve was concerned about the potential loss of customers and suggested that Prairie Winds purchase a second pasta production machine for $40 million. The company had excess space in the existing facility that could be used for the new machinery. However, this space currently was leased to another company on a year-to-year basis and was generating annual rent of $100,000. If new equipment were purchased, the company would need $250,000 for shipping as well as $115,000 in expenses to install the new equipment and get it operational. Also, $2,000 would be needed for addi- tional spare parts inventory to keep the equipment working.
The industrial equipment falls into the seven year MACRS, although its expected economic life is 10 years. At the end of its economic life, it can be salvaged for $1.5 million. Local interest for the expansion was strong, and conversation with growers indicated that 65 percent of the required money could be obtained by a second stock offering. The remainder could be obtained through a collateral-secured loan from the bank. This financing would allow the company to maintain their optimal capital structure of 65 percent equity and 35 percent debt. Steve has recently determined that the cost of equity is 14 percent and the before-tax cost of debt is 10 percent. Market studies had determined a large untapped demand for Prairie Winds’ product. Steve felt that the extra capacity generated by the new machine could increase sales by 130 million pounds per year. Fixed operating costs were expected to increase by $400,000.
The seasonal nature of pasta consumption also has contributed to delivery problems. Pasta consumption is generally down in the warmer months, particularly for long cuts, as people generally prefer lighter dinners. During the summer, demand for a wide variety of short cuts such as shells, elbows, and ziti is stronger, due to increased consumption of pasta salads. In contrast, September and October are peak consumption months for long cuts and demand exceeds the company’s capacity for production. Thus, with seasonal consumption, the long-cuts machines are underutilized in the sum- mer months and operate at peak performance during September and October. Time required for switching the die for each cut adds stress to the shortage of short cuts during the summer months.
To guarantee a timely supply of product, one of the largest northeast customers approached Prairie Winds about the possibility of renting a warehouse. Because of the long shelf life of pasta and recent delivery problems, the warehouse storage would enable Prairie Winds to produce longer runs of each cut of pasta and save some of the time currently required to change dies. Longer runs were expected to boost existing machinery production from its current level of 140 to 145 million pounds. The leased building would allow the company to level production and reduce some of the stress resulting from product shortages. An excellent secured building was available in the Spring- field area and could be leased for 10 years at the rate of $555,000 per year. Another capital budgeting issue facing Prairie Winds is replacing the packaging and labeling machine.
The company currently packages product for each customer under the store brand label. Although the current machine is adequate, it produces a large percentage of defective boxes that requires repackaging. Also, the current machine is slow, and new processes have been developed with increased flexibility and speed. The company paid an industry consultant $25,000 to investigate the availability of new generation labeling machines and the feasibility of replacing the existing machine. This amount was expensed for tax purposes. The two best labeling options include a three- year economic life machine and a five-year economic life machine. The three-year machine costs $1.5 million and is expected to reduce operating costs by $850,000 each year. The salvage value at the end of its useful life is expected to be $500,000.
Although the longer-term machine costs $2.0 million, it is expected to reduce operating cost by $800,000 each year over its five-year life. Its sal- vage value at the end of its useful life is expected to be $120,000. Through a special tax designa- tion both options fall under the 3-year MACRS recovery period. Steve realizes that appropriately addressing the production and shipment issues of the com- pany is critical to the successful operation of the company. A special shareholders’ meeting has been called to discuss possible solutions to the crisis. The agenda also calls for making decisions con- cerning the addition of new production equipment, the replacement of the packaging and labeling machine, and entering into a leasing contract for the warehouse. Steve is responsible for explaining the issues, presenting the facts relating to these decisions, and justifying his recommendations. Since his expertise lies in production and not finance, he has hired you as a consultant to help prepare for the meeting. Steve is aware that the degree of financial sophistication of the meeting participants varies widely and, therefore, he wants the information to include the intuition behind the numbers used in the decision making.
Specifically, he would like a detailed discussion of the pertinent cash flows for each decision. He wants you to compute and explain the project’s payback, net present value, inter- nal rate of return, and profitability. Although the IRR is widely used in the industry, he has learned about problems with this method of capital budgeting and asks you to include the modified internal rate of return model in your presentation. Steve is also concerned about the different lives of the three- and five-year labeling machines and wants you to make sure that the comparisons are valid. Although inflation was relatively flat for the last few years, there was some concern that it would rise again and affect costs and wholesale prices. To ensure the report is thorough, Steve asks that your discussion of the new pasta equipment include the possible effects of inflation. Steve notes that the discount rate is based on quoted, or nominal, market-determined component costs of capital, while both the sales price and the operating cost per unit are in current dollar terms.
He would like to know how that affects the decision. He also wonders whether it would be appropriate to assume neutral inflation equal to the four percent general rate of inflation. If not, he wants to know how sensitive the results would be to alternate assumptions of differential inflation impacts on rev- enues and costs. Finally, although production from the proposed new pasta machinery will be limited to high quality Durham wheat, some of the growers had successfully grown other types of less expensive wheat. They were interested in discussing the impact on the decision if they purchased an addi- tional machine for developing a cheaper grade pasta product that may compete with the Durham wheat product. Since the issue will probably be raised, Steve asks you to briefly discuss the impact of this new product on the capital budgeting decision to purchase the high-grade pasta machine.
Your task is to help Steve perform the analysis and write up a report for the shareholders meet- ing. The company is in a 40 percent tax bracket and requires a 4-year payback on all new projects. To help structure your analysis and report, he has provided you with the following questions. (Hint: If you are not using the spreadsheet model, it would be very time-consuming to quantify your answers to some of the questions. Therefore, in some instances, it would be appropriate to simply think about the situation and indicate the direction in which a change would occur. With the spread- sheet model, quantified answers should be developed where appropriate.)
1. Define the term “incremental cash flow.” Since the project will be financed in part by debt, should the cash flow statement include interest expenses? Explain.
Questions 2 through 11 relate to the initial decision of adding the second pasta machine.
2. What is Prairie Winds Pasta’s Year 0 net investment outlay for the new pasta equipment expansion project? (Hint: Use Table 1 as a guide.)
3. Since Prairie Winds already owns space in the production facility, is this space “free” or “costless” from the standpoint of the additional pasta machine? Explain how the $100,000 in annual rent the company currently receives for space in the facility should be included in the analysis.
4. The addition of competing product lines with a cheaper grade of pasta has been raised. What additional concerns about the high-grade pasta machine must be considered if the company decides to introduce a competitive pasta product to its existing offerings? What if it were believed that if Prairie Winds did not introduce the cheaper product, a competing firm would develop a very similar product? How would Prairie Winds’ decision to purchase the new high-grade pasta machine be affected?
5. What are the expected non-operating cash flows when the project is terminated at Year 10?
6. Estimate the project’s operating cash flows for each year of the project’s economic life. (Hint: Use Table 2 as a guide.)
7. What discount rate should be used as the company’s cost of capital?
8. Compute the project’s NPV, IRR, modified IRR (MIRR), and payback, and explain the rationale behind each of these capital budgeting models.
9. Based on each model, explain why the project should or should not be undertaken. Is it pos- sible to have conflicting decisions with these capital budgeting models?
10. The initial analysis was based on a market-determined nominal cost of capital as the dis- count rate includes an inflation premium. However, the sales price and operating cost per unit were assumed to remain constant throughout the project’s life. This raised the following questions:
a. What are the problems with an analysis in which the discount rate is in nominal terms but the cash flows are measured in current dollar terms, unadjusted for inflation? b. If cash flows are to be adjusted for inflation, is it appropriate to assume that inflation is neutral, i.e., that inflation has the same impact on all elements of the cash flow stream?
11. Answer this question quantitatively only if you are using the spreadsheet model. Consider the effects of inflation on sales price and variable operating costs with inflation beginning after Year 0. For simplicity, assume that no other cash flows (net opportunity costs, salvage value, or net working capital) are affected by inflation. Find the project’s NPV, IRR, MIRR, and payback with inflation taken into account. (Hint: The Year 1 cash flows, as well as suc- ceeding years’ cash flows, must be adjusted for inflation because the original estimates were in Year 0 dollars.)
a. What is the impact if the sales price will increase by a 4-percent inflation rate beginning after Year 0 and cash operating costs will increase by only 2 percent annually from the initial cost estimate? This situation may occur because over half of the costs may be fixed by long-term contracts. b. How would the project’s NPV change if sales price and operating cash costs-per-unit increased at the same rate, 4 percent per year? c. How would the project’s NPV change if sales price rises by only 2 percent, but costs increase by 4 percent per year?
12. Determine the incremental cash flows associated with leasing the warehouse in Mas- sachusetts. Based on the after-tax cash flows, determine the advisability of this option. Dis- cuss some of the other factors that should be considered in this decision.
Questions 13 and 14 relate to the packaging/labeling machine.
13. Should the $25,000 investigation of the new technology be included in the packaging and labeling machine analysis? Explain.
14. Calculate each project’s single-cycle NPV. Based on these values, which project should be undertaken?
15. After adjusting for the life of the projects, which recommendation should be made to the Co- op? Briefly justify your decision.