CASE STUDY
Assume you have
been asked to analyse the decision faced by Julian Bentley with additional
information given below.
1) Mr Reynolds informed Julianthat his loan
application to purchase either type of kiln including installation and expert
testing has been approved. The terms of the loan would be payment of yearly
interest in advance at a fixed rate of 12% per annum over the life of the
project and repayment of the principal owing at maturity.
2) The estimated service life for a gas-fired
kiln is 10 years and six years for an electric kiln. The salvage values for a
gas-fired kiln and an electric kiln at the end of their usable lives are $4,000
and zero[2],
respectively. Julian’s accountant allocated depreciation to the gas-fired kiln
in the modified accelerated cost recovery (MACRS) 10-year class and the
electric kiln could be depreciated using the MACRS category for 5-year assets.
Depreciation allowance percentages according to MACRS are shown in the table
below.
MACRS Allowance Percentages
|
Year
|
5-year assets
|
10-year assets
|
|
1
|
20%
|
10%
|
|
2
|
32%
|
18%
|
|
3
|
19%
|
14%
|
|
4
|
12%
|
12%
|
|
5
|
11%
|
9%
|
|
6
|
6%
|
7%
|
|
7
|
|
7%
|
|
8
|
|
7%
|
|
9
|
|
7%
|
|
10
|
|
6%
|
|
11
|
|
3%
|
3) As you were checking the sales and cost
projections for the new kilns provided by Julian in Exhibit 4, you noted that
he had not made a provision for the increased working capital requirements with
the new equipment. This would entail an initial increase in accounts receivable
of $10,000, an increase in accounts payable of $15,000, and an increase in
inventory of $25,000. Net working capital requirements for subsequent years
will be 10% of additional sales.
4) You had learnt in your postgraduate
finance course that project cash flows typically have different levels of risk.
You had a discussion with Julianto get a feel for the uncertainties involved
the cash flow estimates. Julian concluded that there was little uncertainty in
any of the estimates except for the sales projection, which could vary
significantly depending on the market demand. In his opinion, the sales
projection could deviate from the estimated figure given in Exhibit 4 by plus
or minus 20%.
5) Under the current rental agreement, Julian
has an option to extend the lease for another 10 years at a higher rental
payment of $10,000 per year.
6) Assume the company tax rate is 30% per
annum and the acceptable payback period is 3 years.
Your task is to
prepare the capital budgeting report for Julian Bentley advising whether he
should invest in the new equipment in January 2000. Your report should include
the answers to the following Questions 1 to 7. It is important to list your
assumptions in applying the capital budgeting techniques, and show clearly the
workings in deriving your results. Your assignment will be graded based on presentation,
understanding of the issues and logical explanation, and accuracy of
calculations in solving the problems. The mark allocations for individual
questions(including 20 marks for presentation) will total 125 marks and will be
scaled by a factor of 0.2 to produce a mark consistent with 25% weighting in
the unit assessment.
QUESTIONS
1. Based on the information given in the
case, prepare two cash flow tables (which incorporate taxes and include initial
investment, operating and terminal cash flows) for the purchase of 3 gas-fired
kilns and 12 electric kilns. Decide if each of the following items should be
included in the cash flow table. Explain your decision.
a) The
increase in accounts receivable, accounts payable and inventory;
b) The
term loan and the yearly interest expense;
c) The
increase in rental payment after seven years;
d) The
estimates of higher utilities expense.
Explain clearly your assumptions in
deriving the figures in your cash flow.
[37
marks]
2. What are the implications of mutually
exclusive projects; would you characterise the electric and gas-fired kilns as
mutually exclusive; why or why not?
[4
marks]
3. What is the appropriate cost of capital to
use for discounting expected future cash flows?
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