Evaluating Plywood Presses: A Case Study in Capital Budgeting

This case study follows Emily Jones, a recent graduate, as she begins her career at Albany Building Supplies (ABS) and is tasked with evaluating two new plywood presses for the company. The General Manager, Thomas Wilson, has a distinct set of capital budgeting practices, relying on payback methods and average accounting rate of return (AARR) for smaller investments, but using his judgment for larger investments. He also places great emphasis on forecasting accuracy, believing that "forecasters need to be 'honest seekers of truth' if the company is to be the best it can be." Jones, however, sees the lack of discounted cash flow techniques as a potential flaw in Wilson's approach.

The case presents a detailed financial analysis of the two plywood presses, the Nakoi and the Dakota, using various growth rate scenarios for selling prices and cash costs. This analysis highlights the sensitivity of the NPV (net present value) to these growth rates, demonstrating the importance of accurate forecasting in capital budgeting decisions. Jones is tasked with providing recommendations based on her analysis, emphasizing the need to not only be correct but also clearly justify and explain her recommendations.

Evaluation of the Plywood Presses

Jones initially evaluated the presses using Wilson's provided data, but he later revised the information, prompting a re-evaluation. The key revisions included an increase in plywood selling price by 4% per year, a corresponding increase in cash costs, and a discount rate of 17%. This revised evaluation showed that the Nakoi press had a positive NPV while the Dakota press had a negative NPV, making the Nakoi the more financially attractive option.

The analysis then explored different growth rate scenarios, considering varying rates for both selling prices and cash costs. The results revealed that the NPVs of both machines were highly sensitive to these growth rates. In some scenarios, both presses had positive NPVs, while in others, both had negative NPVs.

Importance of Forecasting Accuracy

The case emphasizes the critical importance of accurate forecasting in capital budgeting decisions. The sensitivity of the NPV to growth rate assumptions highlights the potential for inaccurate forecasts to lead to misguided investment choices. Wilson's strong focus on forecasting accuracy, including his personal investigations and hiring of outside consultants for post-audit comparisons, reflects the importance he places on this aspect of the process.

Considerations for Improvement

The case also suggests areas for improvement in Wilson's capital budgeting practices. The lack of discounted cash flow techniques is a noticeable omission, and Jones's understanding of market returns suggests that Wilson might be open to incorporating these techniques into his decision-making. This would allow for a more sophisticated and comprehensive evaluation of potential projects.

Learning Outcomes

This case study offers several learning opportunities for students of finance and business:

• Capital Budgeting Techniques: Provides practical experience with various capital budgeting techniques including payback period, average accounting rate of return (AARR), and net present value (NPV).
• Forecasting Accuracy: Emphasizes the importance of accurate forecasting in capital budgeting decisions and highlights the potential consequences of inaccurate estimates.
• Sensitivity Analysis: Illustrates the use of sensitivity analysis to understand the impact of various assumptions on project outcomes.
• Decision-Making Under Uncertainty: Explores the challenges of making investment decisions in the face of uncertainty and the importance of incorporating a range of potential scenarios into the analysis.