Capital Budgeting Analysis of Plywood Presses: A Case Study of 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), focusing on the evaluation of two plywood presses. We'll analyze the decision-making criteria used by Thomas Wilson, the General Manager, and provide recommendations for Emily Jones, a recent hire tasked with evaluating the investment.

The Situation

ABS, a timber industry company, is considering expanding its plywood production capacity. Thomas Wilson, known for his direct approach, favors simpler metrics like payback period and average accounting rate of return (AARR). Emily Jones, with her academic background, recognizes the need for discounted cash flow (DCF) techniques like Net Present Value (NPV) for a comprehensive evaluation.

Challenges

The case highlights several challenges:

• Conflicting Evaluation Methods: Wilson relies on payback and AARR, which don't fully account for the time value of money, while Jones sees the value in DCF analysis.* Accuracy of Forecasts: Wilson emphasizes accurate forecasting but relies heavily on personal judgment and past experiences, potentially overlooking market dynamics.* Discount Rate Selection: While Wilson acknowledges market returns, the case doesn't specify how the discount rate is determined, impacting the reliability of the analysis.

Analysis

Let's analyze the two plywood presses using the revised information:

Assumptions:

• Plywood selling price increases by 4% per year.* Cash costs increase by 4% per year.* Material costs are 72% of sales.* Discount rate is 17%.* Other estimates remain unchanged.

Methodology:

1. Revenue Projection: Calculate annual revenue for each machine considering output, usage days, and price escalation.2. Cost Estimation: Determine annual costs, including material (as a percentage of sales), labor, maintenance, and overhead, factoring in the 4% escalation.3. Depreciation: Calculate annual depreciation using the straight-line method over the seven-year life.4. Cash Flow Calculation: Compute annual before-tax and after-tax cash flows.5. Present Value Determination: Discount after-tax cash flows using the 17% discount rate.6. Net Present Value (NPV) Calculation: Calculate the NPV by subtracting the initial investment from the present value of cash flows.

Results:

Based on the revised assumptions and calculations, both machines yield negative NPVs, indicating they are not financially viable investments.

Recommendations

1. Adopt Discounted Cash Flow (DCF) Analysis: Implement DCF techniques like NPV and Internal Rate of Return (IRR) to supplement traditional metrics for a comprehensive evaluation.2. Formalize Discount Rate Determination: Establish a clear and consistent method for determining the discount rate, considering factors like cost of capital and risk-free rate.3. Enhance Forecasting Accuracy: Develop a more robust forecasting process incorporating market research, industry trends, and expert opinions to improve accuracy.4. Sensitivity Analysis: Conduct sensitivity analysis to assess the impact of changes in key variables like plywood prices, discount rate, and cost inflation on the investment decision.

Conclusion

By adopting a more structured and comprehensive approach to capital budgeting, ABS can make better-informed investment decisions, optimize resource allocation, and enhance long-term profitability. This case underscores the importance of integrating financial theory with practical considerations in a dynamic business environment.