Capital Budgeting at Albany Building Supplies: A Case Study in Financial Analysis

Capital Budgeting at Albany Building Supplies: A Case Study

The Situation: Emily Jones, a recent graduate, is tasked with evaluating two new plywood presses for Albany Building Supplies (ABS). Her analysis will inform a major investment decision by the firm's General Manager, Thomas Wilson.

The Challenge: Jones must navigate Wilson's existing capital budgeting practices, which rely heavily on payback period and average accounting rate of return (AARR). While simple, these methods don't fully account for the time value of money. Jones needs to provide a thorough analysis while also introducing more sophisticated financial tools like net present value (NPV) and internal rate of return (IRR).

Key Factors:

• Machine Comparison: The Japanese-made Nakoi press is less expensive but has lower output and higher labor costs compared to the American-made Dakota press.* Financial Evaluation: Jones must consider factors such as initial investment, operating costs, depreciation, tax rates, and the company's target rate of return.* Growth Rate Sensitivity: Wilson is unsure about his growth rate assumptions for selling price and cash costs. Jones needs to analyze how different growth scenarios impact the investment decision.* Forecasting Accuracy: Wilson emphasizes the importance of accurate forecasting and has implemented rigorous procedures to ensure realistic projections.* Discounted Cash Flow Analysis: Jones recognizes the limitations of ABS's current methods and plans to incorporate NPV and IRR into her analysis to provide a more comprehensive evaluation.

The Analysis: Jones will need to build a detailed financial model in a spreadsheet to compare the two machines under various scenarios. Key outputs will include:

• Net Present Value (NPV): This will determine the present value of the future cash flows generated by each machine, discounted at the company's required rate of return.* Internal Rate of Return (IRR): This will calculate the discount rate at which the NPV of each project equals zero, providing another measure of investment profitability.* Sensitivity Analysis: Jones will perform sensitivity analysis to assess how changes in key assumptions (e.g., growth rates, discount rate) impact the NPV and IRR.

The Recommendation: Based on her analysis, Jones will recommend the machine with the highest NPV and an IRR exceeding the company's hurdle rate. Her report will need to clearly articulate the financial rationale for her recommendation, highlighting the strengths and weaknesses of each option.

Key Takeaways: This case study illustrates the importance of:

• Using appropriate financial tools: While simple metrics like payback period have their place, discounted cash flow analysis provides a more accurate assessment of investment profitability.* Understanding the limitations of financial models: Sensitivity analysis is crucial to assess the impact of uncertainty and ensure robust decision-making.* Clearly communicating financial insights: Jones needs to present her findings in a clear and concise manner to effectively persuade Wilson and influence the investment decision.