Capital Budgeting Analysis: Comparing Plywood Presses for Albany Building Supplies

Capital Budgeting at Albany Building Supplies: A Case Study

Introduction

This case study examines the capital budgeting process at Albany Building Supplies (ABS), a timber company based in Albany, New Zealand. The company's General Manager, Thomas Wilson, is considering purchasing a new plywood press to expand production capacity. We follow Emily Jones, a recent graduate, as she evaluates two potential presses and navigates ABS's existing capital budgeting framework.

The Plywood Press Decision

ABS's plywood division is nearing production capacity. To capitalize on growing demand, Wilson is deciding between two plywood presses: the Japanese-made Nakoi and the American-made Dakota.

The Dakota boasts a higher production rate, lower labor costs, and potentially better resale value. However, it comes at almost double the cost of the Nakoi. Jones must determine if these advantages justify the price difference.

ABS's Capital Budgeting Practices

Wilson employs a pragmatic approach to capital budgeting, which he refers to as his 'Fixed Asset Purchase Guidelines' (FAPG). Key elements include:

• Industry Alignment: Projects must fall within the timber industry.* Payback Period: A crucial metric for both small and large investments, with shorter paybacks preferred.* Average Accounting Rate of Return (AARR): Used for larger projects, with a target exceeding the firm's book return of 20%.

Forecasting and Risk Management

Wilson emphasizes accurate forecasting, demanding 'honest seekers of truth' from his team. He monitors forecasts closely and employs post-audits to ensure accuracy and minimize bias. Interestingly, ABS's forecasts tend to be conservative, with actual cash flows often exceeding projections.

Challenges and Opportunities

Jones identifies a significant gap in ABS's capital budgeting process: the absence of discounted cash flow (DCF) analysis. While Wilson acknowledges the difference between book and market returns, incorporating market-based discounting could lead to more informed decisions.

Financial Analysis

Jones must re-evaluate the presses using revised information from Wilson, including:

• Plywood selling price increasing by 4% annually.* Cash costs increasing by 4% annually.* Material costs representing 72% of sales.* A discount rate of 17%.

Using these inputs, Jones needs to calculate the net present value (NPV) of each press to determine the most financially viable option.

Conclusion

This case highlights the complexities of capital budgeting in a real-world setting. By analyzing the financial viability of each press and understanding the nuances of ABS's existing framework, Jones can make informed recommendations to Wilson. Additionally, her understanding of DCF analysis presents an opportunity to enhance the company's decision-making process for future investments.