Capital Budgeting at Albany Building Supplies: A Case Study of Thomas Wilson's Decision-Making

Thomas Wilson, the General Manager of Albany Building Supplies (ABS), is being quite frank with Emily Jones, a recent employee. 'As I told you at our interview, I'm hiring you despite your BBS. I haven't had good experiences with degree graduates. They tend to be too technical, lack communication skills, and view problems as mere academic exercises. But you seem to be different. Your recommendations cited your sensitivity to real-world complexities and I've been impressed with your communication and people skills. I think you can help us.'

Jones received her BBS four weeks ago from Massey University, a tertiary institute that has a strong national and international reputation. She received a number of 'big city' job offers but turned them down to accept a position with ABS, a firm based in Albany, north of Auckland.

Jones took the job because she wanted a position with a smaller firm where she 'could make a difference,' the company is located very near her family home, and the compensation is surprisingly attractive. She is also impressed with Thomas Wilson. Though a bit gruff, he seems sharp, fair, direct, and willing to give her much job-freedom and responsibility. In fact, her first assignment is of some importance and consists of two parts. Wilson wants Jones to: (1) perform a financial evaluation on two new machines that he is considering and (2) 'critique' the company's capital budgeting policies.

PLYWOOD PRESSES

The plywood division is an important component of the firm's business and nearly two entire plants are devoted to the production of plywood panels. In brief, the production process involves gluing a thin layer of wood to each side of a particle-board that forms the core of the plywood. The plywood is then cut into panels of various sizes suitable for the manufacturing of furniture.

The plywood division is operating very close to capacity and Wilson is seriously considering the purchase of an additional plywood press in order to expand the division's production capability. He has narrowed the choice to two models: the Nakoi, which is made in Japan, and an American-manufactured Dakota.

The Nakoi costs $750,000 and Dakota $1,300,000, both figures including installation. The Dakota has three advantages over the Nakoi. First, because it is a bit faster its daily production rate is higher, and Wilson is confident he could sell the extra output. Second, labor costs will be lower since it is easier to operate. Finally, the Dakota should hold its value better because it is a more state-of-the-art press. Still, the Dakota is nearly twice as expensive and Wilson isn't sure these advantages are worth the extra cost.

Exhibit 1 shows information on each machine. For the purpose of analysis, straight-line depreciation will be used over the seven-year time horizon of the project. The relevant tax rate is 40 percent.

The purchase of either machine will cause a modest increase in inventory and receivables. Wilson thinks that these increases will be almost completely offset by changes in accounts payable and accruals. Thus, on balance, working capital requirements for both machines will be negligible and can be ignored in any evaluation.

WILSON'S 'FAPG'

Wilson then explains his capital budgeting practices, which he calls his fixed asset purchase guidelines ('FAPG'). The first step is to make sure that a proposal fits with the company's mission. Wilson is 'simply not interested in projects outside the timber industry.' He is quick to add that nearly all proposals fall within the industry though occasionally one 'seems far-out.' As an example, Wilson recalls a suggestion that the firm buy a local convenience store. 'No way I'd do this. After all, I have enough headaches with the timber industry. One industry is about all I can handle.'

For relatively small investments the company relies exclusively on the pay-back method. There is no set guideline but Wilson admits that he wants to see 'at least a two-year payback, three years tops.' And he defines a 'small investment' as a project less than $10,000 and 'maybe as much as $15,000.' Examples include the replacement of relatively inexpensive equipment and the installation of energy-saving devices.

Wilson uses somewhat different techniques for more expensive proposals, such as a plant modernization, an expansion, or the purchase of a new plywood press. The payback is still used in part because Wilson uses it as a measure of risk, and in part because it is simple to calculate and easy to understand.

He also wants a measure of the project's expected return and – based on the suggestion of a friend with a strong accounting background – the firm calculates the investment's average accounting rate of return (AARR). The AARR is determined by dividing the project's average annual net income by its average book value. An example of the AARR is presented in Exhibit 2.

In order to be acceptable, a relatively large investment must pass two tests. First, the AARR must exceed the firm's target book return. This book return is currently 20 percent, the figure that Wilson uses to evaluate the performance of the firm's plant managers.

In addition, the project must have an 'acceptable payback.' Wilson explains, 'I use my judgment about what is an 'acceptable' payback. There are no strict guidelines.' He admits, though, that he doesn't like to see a project's payback exceed five years.

FORECASTING ACCURACY

In Wilson's view the most important part of a capital budgeting decision is the accuracy of the forecasts, and he goes to great lengths to make this clear to the firm's executives. He constantly reminds them that 'forecasters need to be 'honest seekers of truth' if the company is to be the best it can be.'

He monitors the company's forecasting efforts in two ways. First, if a project's payback looks 'suspiciously low,' he personally investigates the forecast. Second, from time to time Wilson has hired outside consultants to compare the actual cash flows of a project with those predicted. And if a set of estimates looks 'severely optimistic,' then Wilson will question the forecasters, perhaps intensively. As he puts it, 'I had better receive satisfactory answers to my questions.' Executives who Wilson thinks are negligent or allowing personal bias to cloud their judgment face a severe reprimand and even dismissal in one extreme case. Wilson is aware that many companies are plagued by overly optimistic forecasts, and he is proud of the fact that a post audit indicated that this has not been true for ABS. In fact, there appears to be a tendency for the forecasts to be too conservative. That is, the post audit showed that on average the predicted cash flows were less than the actual cash flows.

REFLECTIONS

Back at her apartment that evening Jones reflected on her meeting with Wilson. She sees 'both good and not so good' with Wilson's capital budgeting procedures. Perhaps the biggest negative is the lack of any discounted cash flow technique. It is clear to Jones, however, that Wilson recognizes that the 20 percent target return is a book and not a market rate. It also appears that Wilson is willing to consider 'capital budgeting techniques based on market returns,' as he puts it. Conversations with Wilson suggest that a 15 percent market return would be acceptable. That is, Jones thinks that Wilson would undertake a project if he felt that the expected return exceeded 15 percent per year.

Jones is pleased at the responsibility of the assignment and is eager to 'make a difference.' At the same time, however, she is a bit apprehensive. Jones realizes that Wilson will take her report very seriously, and knows that her recommendations must not only be correct, but must also be clearly justified and explained.

ADDITIONAL INFORMATION FOR NPV CALCULATION:

(i) The selling (market) price of plywood increases by 4 percent per year. (ii) Cash costs also increase by 4 percent per year. (iii) Material costs will run 72 percent of sales. (iv) The appropriate discount rate is 17 percent. (v) Other estimates are at their original values.

Use an Excel spreadsheet to solve for the NPV using this information.

EXHIBITS:

EXHIBIT 1: Information on the Plywood Presses

| Feature | Nakoi | Dakota | |---|---|---| | Output per day (square feet) | 6,000 | 7,000 | | Days used each year | 240 | 240 | | Market price per square foot of plywood | $1.80 | $1.80 | | Raw materials (% of sales) | 70 | 70 | | Annual labor cost | $276,000 | $226,000 | | Annual maintenance cost | $52,000 | $60,000 | | Annual overhead (cash) | $78,000 | $60,000 | | Year 7 after-tax market value | $75,000 | $390,000 |

EXHIBIT 2: Example of the Average Accounting Rate of Return

The example assumes that a project's initial cost is depreciated over the life of the project on a straight-line basis.

| Year | Initial project cost | Accumulated depreciation | Book value | Net Income | |---|---|---|---|---|
| 0 | $8 | $0 | $8 | NA | | 1 | | $2 | $6 | $1 | | 2 | | $4 | $4 | $2 | | 3 | | $6 | $2 | $2 | | 4 | | $8 | $0 | $1 |

Average Book Value = $4 Average Net Income = $1.5 AARR = $1.50/4 = .375 = 37.5%

EXHIBIT 3: Calculation of Straight Line Depreciation

Depreciation Amount (per year) = (Cost - Residual Value) / Years of Project (Economic Life)

EXCEL SPREADSHEET CALCULATION FOR NPV:

| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | |---|---|---|---|---|---|---|---|---|
| Nakoi | | | | | | | | | | Initial Cost | -$750,000 | | | | | | | | | Depreciation | | $96,429 | $96,429 | $96,429 | $96,429 | $96,429 | $96,429 | $96,429 | | Sales | | $2,073,600 | $2,160,384 | $2,248,796 | $2,338,952 | $2,430,868 | $2,524,560 | $2,620,044 | | Material Costs | | $1,491,072 | $1,555,004 | $1,620,196 | $1,686,712 | $1,754,612 | $1,823,956 | $1,894,808 | | Labor Costs | | $276,000 | $286,080 | $296,282 | $306,609 | $317,064 | $327,650 | $338,369 | | Maintenance Costs | | $52,000 | $53,960 | $55,969 | $58,029 | $60,141 | $62,308 | $64,532 | | Overhead (cash) | | $78,000 | $80,880 | $83,838 | $86,875 | $89,994 | $93,197 | $96,486 | | EBIT | | $175,528 | $184,460 | $193,511 | $202,685 | $211,985 | $221,416 | $230,981 | | Tax (40%) | | $70,211 | $73,784 | $77,404 | $81,074 | $84,795 | $88,570 | $92,399 | | Net Income | | $105,317 | $110,676 | $116,107 | $121,611 | $127,190 | $132,846 | $138,582 | | After-Tax Market Value | | | | | | | | $75,000 | | Total Cash Flow | | $196,429 | $207,095 | $212,526 | $217,695 | $222,921 | $228,234 | $233,611 | | Discount Factor (17%) | | 0.8547 | 0.7305 | 0.6244 | 0.5337 | 0.4561 | 0.3909 | 0.3352 | | Present Value | | $167,590 | $151,468 | $133,026 | $116,295 | $102,455 | $88,846 | $78,676 | | Dakota | | | | | | | | | | Initial Cost | -$1,300,000 | | | | | | | | | Depreciation | | $131,429 | $131,429 | $131,429 | $131,429 | $131,429 | $131,429 | $131,429 | | Sales | | $3,024,000 | $3,153,600 | $3,285,504 | $3,419,779 | $3,556,484 | $3,695,679 | $3,837,424 | | Material Costs | | $2,178,048 | $2,267,392 | $2,358,955 | $2,452,784 | $2,548,920 | $2,647,404 | $2,748,277 | | Labor Costs | | $226,000 | $233,520 | $241,260 | $249,224 | $257,417 | $265,844 | $274,510 | | Maintenance Costs | | $60,000 | $62,400 | $64,896 | $67,489 | $70,182 | $72,977 | $75,878 | | Overhead (cash) | | $60,000 | $62,400 | $64,896 | $67,489 | $70,182 | $72,977 | $75,878 | | EBIT | | $499,952 | $537,888 | $577,397 | $618,507 | $661,256 | $705,685 | $751,835 | | Tax (40%) | | $199,981 | $215,155 | $230,959 | $247,403 | $264,498 | $282,256 | $300,689 | | Net Income | | $299,971 | $322,733 | $346,438 | $371,104 | $396,758 | $423,429 | $451,146 | | After-Tax Market Value | | | | | | | | $390,000 | | Total Cash Flow | | $431,429 | $454,158 | $478,167 | $502,533 | $527,181 | $552,096 | $841,595 | | Discount Factor (17%) | | 0.8547 | 0.7305 | 0.6244 | 0.5337 | 0.4561 | 0.3909 | 0.3352 | | Present Value | | $368,668 | $331,463 | $298,744 | $268,536 | $240,756 | $215,272 | $282,469 |

NPV of Nakoi = $78,676.11 NPV of Dakota = $61,059.12

Based on these calculations, the Nakoi press has a higher NPV and would be the better investment choice for ABS. However, it is important to note that Wilson's FAPG also considers other factors such as the project's expected return and payback period, so these should also be taken into account in making a final decision.