Capital Budgeting Analysis: Choosing Between Two Plywood Presses

Capital Budgeting at Albany Building Supplies: A Case Study

Introduction

This case study examines the capital budgeting practices of Albany Building Supplies (ABS), a timber company facing a crucial investment decision. Emily Jones, a recent graduate, is tasked with evaluating two plywood presses: the Nakoi and the Dakota. This analysis will utilize discounted cash flow techniques to determine the most financially viable option.

The Challenge: Choosing the Right Plywood Press

ABS's plywood division operates near capacity, prompting General Manager Thomas Wilson to consider purchasing a new press. Two options are on the table:

• Nakoi: A Japanese-made press costing $750,000.* Dakota: An American-made press costing $1,300,000.

While the Dakota boasts higher output, lower labor costs, and potentially better resale value, its significantly higher upfront cost warrants careful consideration.

Evaluating the Options: A Discounted Cash Flow Approach

Emily Jones recognizes the limitations of ABS's existing capital budgeting practices, which rely heavily on payback period and AARR, neglecting the time value of money.

To provide a more robust evaluation, a discounted cash flow (DCF) analysis is crucial. This involves:

1. Estimating Cash Flows: Projecting the incremental cash inflows and outflows associated with each press over the project's lifespan. This includes factoring in revenues, material costs, labor costs, maintenance, overhead, depreciation, and taxes.2. Determining the Discount Rate: This reflects the opportunity cost of capital and should align with the company's risk profile. Jones believes a 15% market return would be acceptable to Wilson.3. Calculating Net Present Value (NPV): Discounting all future cash flows to their present value using the chosen discount rate. The press with the higher NPV represents the more financially attractive option.

Sensitivity Analysis: Assessing the Impact of Uncertainty

Given the importance of accurate forecasting, sensitivity analysis is essential. This involves:

• Varying Growth Rates: Examining the impact of different growth rates for selling prices and cash costs on the NPV of each press. * Analyzing Cost Fluctuations: Considering scenarios where cash costs might escalate faster than selling prices.

By understanding how sensitive the NPV is to changes in key assumptions, Jones can provide Wilson with a more informed recommendation.

Conclusion: Guiding ABS Towards a Sound Investment Decision

By incorporating DCF analysis and sensitivity analysis into the evaluation process, Jones can provide ABS with a comprehensive assessment of the Nakoi and Dakota presses. This will enable Wilson to make a well-informed decision that aligns with the company's long-term financial goals.

Further Analysis: Expanding on Key Considerations

• The case study provides detailed financial data in Exhibits 1 and 2, which can be used to perform the DCF and sensitivity analysis.* Exploring different depreciation methods and their impact on NPV could provide additional insights.* Qualitative factors, such as potential technological advancements and changes in market demand, should also be considered alongside the quantitative analysis.