Capital Budgeting and Financial Evaluation of Plywood Presses: A Case Study

Capital Budgeting and Financial Evaluation of Plywood Presses: A Case Study

This case study follows Emily Jones, a recent graduate, as she navigates her first assignment at Albany Building Supplies (ABS). Tasked with evaluating two new plywood presses and critiquing the company's capital budgeting policies, Jones encounters a challenging scenario involving growth rate estimations and their impact on investment decisions.

The Challenge:

ABS, a timber company, needs to increase its plywood production capacity. The General Manager, Thomas Wilson, considers two options: the Nakoi and the Dakota plywood presses. While the Dakota offers higher production, lower labor costs, and better value retention, it comes at almost double the price of the Nakoi.

Capital Budgeting Practices at ABS:

Wilson employs a combination of payback period and average accounting rate of return (AARR) for evaluating investments. He emphasizes 'honest' forecasting and closely monitors actual cash flows against predictions. While acknowledging the limitations of his current methods, Wilson shows openness to incorporating market returns and discounted cash flow techniques.

The Evaluation:

Jones' initial evaluation is quickly outdated when Wilson revises key assumptions, including a 4% annual growth in selling price and cash costs, and a 17% discount rate. Using these inputs, the analysis reveals that the Dakota press, despite its higher initial cost, yields a positive net present value (NPV) of $1,354,953, while the Nakoi press shows a negative NPV of $912,911.

Sensitivity Analysis:

Recognizing the uncertainty surrounding growth rates, Jones conducts a sensitivity analysis by evaluating the machines under various growth scenarios. This analysis reveals that the NPV of the Dakota press is highly susceptible to changes in growth rates, highlighting the importance of accurate forecasting.

Key Takeaways:

The case study underscores the following critical aspects of capital budgeting:

• Importance of Discounted Cash Flow (DCF) Techniques: While payback period and AARR offer simplicity, DCF methods like NPV provide a more comprehensive evaluation by considering the time value of money.- Sensitivity Analysis is Crucial: Relying solely on a single set of assumptions can be misleading. Sensitivity analysis, by evaluating different scenarios, helps assess the risk associated with different variables.- Accurate Forecasting is Paramount: The accuracy of cash flow forecasts significantly impacts the reliability of any capital budgeting decision. As demonstrated in the case, even slight variations in growth rates can drastically alter the outcome.

Conclusion:

Jones' evaluation highlights the complexities involved in capital budgeting decisions. By incorporating DCF techniques, conducting sensitivity analysis, and emphasizing accurate forecasting, businesses can make more informed investment choices and maximize shareholder value. This case serves as a valuable lesson for aspiring financial professionals navigating the challenges of capital budgeting in a dynamic business environment.