Evaluating Plywood Press Investments: A Case Study in Capital Budgeting

Emily Jones, a recent graduate with a Bachelor of Business Studies (BBS) degree, has landed a position at Albany Building Supplies (ABS), a timber firm based in Albany, New Zealand. While her BBS degree initially raised concerns from the company's General Manager, Thomas Wilson, her communication skills and real-world understanding impressed him. Jones' first assignment is a crucial one: evaluating two new plywood presses, the Nakoi and the Dakota, for their potential to expand the company's plywood division.

Wilson, known for his directness and willingness to give his employees significant responsibilities, laid out his capital budgeting practices, which he calls his 'fixed asset purchase guidelines' (FAPG). He emphasizes the importance of aligning projects with the company's mission, which is firmly rooted in the timber industry. For smaller investments, Wilson relies on the payback method, aiming for a payback period of at least two years. However, for larger investments, such as the plywood press purchase, he employs a combination of the payback method, average accounting rate of return (AARR), and a target book return of 20%.

Jones' task involves re-evaluating the plywood presses using revised information provided by Wilson. The new information includes a 4% annual increase in selling and cash costs, material costs representing 72% of sales, a 17% discount rate, and other estimates remaining unchanged. This requires Jones to perform a thorough financial analysis, comparing the net present value (NPV) of each option.

To calculate the NPV, Jones uses the formula: NPV = -Initial Investment + (Cash Flows / (1 + Discount Rate)^n), where 'n' represents the year of the cash flow. The cash flows are determined by considering the market price per square foot of plywood, output per day, days used each year, raw material costs, labor costs, maintenance costs, overhead costs, and after-tax market values. Jones also incorporates straight-line depreciation to calculate the annual depreciation expense.

After applying the updated information and discount rate, Jones calculates the NPV for each plywood press. The results indicate that the Dakota press has a higher NPV than the Nakoi press. This suggests that the Dakota press is the more financially viable option, given the revised assumptions.

Jones' initial assessment of Wilson's capital budgeting practices reveals a mixture of strengths and weaknesses. While she acknowledges the lack of any discounted cash flow technique, she also recognizes that Wilson understands the distinction between book and market rates of return. Wilson's willingness to consider capital budgeting techniques based on market returns, with an acceptable market return of 15%, demonstrates his openness to incorporating more sophisticated methods.

Jones faces the challenge of presenting her findings to Wilson, recognizing the importance of her recommendations being both accurate and well-justified. This case study highlights the crucial role of accurate forecasting, discounted cash flow analysis, and managerial judgement in making sound capital budgeting decisions. By understanding the company's unique practices, incorporating new information, and employing appropriate financial analysis, Jones can effectively evaluate the plywood press investments and provide valuable insights to ABS.