Question

1

The information in this mini case is fictitious and

the case is used for instruction purpose only. Case

questions are provided at the bottom.

Kensington Plastics

In December 2017, Michael Roberts, managing direct

or of Kensington Plastics, was considering

the purchase of a PlaTech 2 automated injecti

on molding machine. The PlaTech 2 would replace

older semiautomated machines and would offer

improvement in quality and some additional

capacity for expansion. Given the size of the pr

oposed expenditure of $2.15 million, Roberts was

seeking a careful estimate of the project's costs

and benefits and, ultimately, a recommendation of

whether to proceed with the investment.

The Company

Kensington Plastics speciali

zed in the production of high qua

lity plastic products for use

in automotive equipment. The company had acqui

red a reputation for quality products. Its products

included seat bases and door trim

panels for cars. Customers we

re increasingly

insistent about

product quality, and Kensington Plastics' response had re

duced the defect rate of

its products to 10

parts per 100,000.

This record had won the company quality

awards from major car manufacturers

including GM, Ford, and Nissan, and had resulted

in strategic alliances with these firms.

Kensington Plastics and these ca

r manufacturers exchanged technical personnel and design tasks.

In addition, the car manufacturer

s shared important market-dema

nd information with Kensington

Plastics, which increased the precision of the la

tter's production scheduling.

In certain instances,

the car manufacturers had provided cheap loans

to Kensington Plastics to support capital

expansion. Finally, the company received relative

ly long-term supply contracts from these car

manufacturers and had a preferential

position for bidding

on new contracts.

Kensington Plastics, located

in Detroit, Michigan, was founded in 1965 by Roberts's

grandfather, John Roberts, a mechanical engine

er, to produce plastic parts for the automobile

industry. Kensington Plastics

grew slowly but steadily; its

sales for calendar-year 2017 were

expected to be $70 million. The company was liste

d for trading on the New York Stock Exchange

(NYSE) in 1995, but the Roberts family owned 51%

of the common shares of stock outstanding.

2

The company's beta was estimated at 1.35. Currentl

y, the 3-month Treasury

Bill yields 2.75%. The

average market risk premium over the

last 100 years was approximately 7%.

The company's traditional hurdle rate of return on capital deployed was 9%, although

this rate had not been reviewed since 2014. In

addition, company policy

sought payback of an

entire investment within five years. At the tim

e of the case, the market

value of the company's

capital was 40% debt and 60% equity. The preva

iling borrowing rate Kensington Plastics faced on

its loans was 6.5%. The company's effective tax rate was about 40%, which reflected the

combination of federal and local

corporate income-tax rates.

Roberts, age 55, had assumed executive res

ponsibility for the comp

any 5 years earlier,

upon the death of his father. He held a doctorate in

plastic engineering. Over

the years, the Roberts

family had sought to earn a rate of re

turn on its equity investment of 13.5%.

The PlaTech 2 Injection Molding Machine

The new injection molding machine would re

place six semiautomated injection molding

machines that together had originally co

st $650,000. Cumulative depreciation of $260,000 had

already been charged against the original cost a

nd six years of depreciation charges remained over

the total useful life of 10 y

ears. Kensington Plastics' management believed that those

semiautomated machines would need to be replaced

after six years. Roberts had recently received

an offer of 250,000 for the six machines. The curre

nt six machines required 12 workers per shift

(24 in total) at $15.00 per worker per hour, plus th

e equivalent of two main

tenance workers, each

of whom was paid $15.50 an hour, plus mainte

nance supplies of $9,500 a year. Roberts assumed

that the semiautomated machines, if kept, would c

ontinue to consume electrical power at the rate

of $24,000 a year.

The PlaTech 2 injection molding machine

was produced by a company in Cleveland,

Ohio. Kensington Plastics had received a firm offe

ring price of $2 million from the Ohio firm. The

estimate for modifications to the plant, incl

uding wiring for the machine's power supply, was

$120,000. Allowing for $30,000 for transportation, installa

tion, and testing, the total cost of the

PlaTech 2 machine was expected to be $2.15 m

illion, all of which woul

d be capitalized and

depreciated for tax purposes over eight years. Robe

rts assumed that, at a

high and steady rate of

machine utilization, the Platech 2 wo

uld be worthless after the eighth

year and need to be replaced.

3

The new machine would require two skilled

operators (one per sh

ift), each receiving

$21.50 an hour (including benefits), and contract

maintenance of $100,000 a year, and would incur

power costs of $37,000 yearly. In addition, the auto

matic machine was expected to save at least

$50,000 yearly through improved labor efficiency

in other areas of the production.

Certain aspects of the PlaTech 2 purchase

decision were difficult to quantify. First,

Roberts was unsure whether the tough collective-

bargaining agreement his company had with the

employees' union would allow her to lay off the

24 operators of the semiautomated machines.

Reassigning the workers to other jobs might be easier, but the only positions needing to be filled

were unskilled jobs, which paid

$12.50 an hour. The extent of a

ny labor savings would depend on

negotiations with the union. Sec

ond, Roberts believed that the

PlaTech 2 would

result in even

higher levels of product quality and lower defect

rates than the company was now boasting. In

light of the ever-increasing comp

etition, this outcome might prove

to be enormous, but currently

unquantifiable, competitive importance. Finall

y, the PlaTech 2 had a theoretical maximum

capacity that was 30% higher than that of the

six semiautomated machines; but those machines

were operating at only 90% of capacity, and Robe

rts was unsure when adde

d capacity would be

needed. There was plenty of uncertainty about

the economic outlook in th

e U.S., and the latest

economic news suggested that the economies of

the U.S. might be headed for a slowdown.

4

Kensington Plastics case questions

1.

Please assess the economic benefits of ac

quiring the PlaTech 2 machine (assume 210

working days per year):

a.

What is the initial investment?

b.

What are the benefits over time?

c.

What is the appropria

te discount rate?

d.

Does the net present value (NPV) warrant the investment in the machine?

2.

What uncertainties or qualitative consid

eration might influence your recommendation?

Example:

a.

Inflation

b.

Discount rate

c.

Inability to lay off existing workers

d.

A reduction in the daily operating

hours due to economic slowdown

...

Please estimate the impact on NPV from a change in at least one of those elements.

3.

Should Michael Roberts proceed with the project? Explain.

Answer 1

1. Assessment of economic benefits of acquiring PlaTech 2 machine
a. What is the initial investment
			$
Cost of PlaTech2			2150000
Less: scrap value of 6 semi
automated machines			-250000
Net Initial investment			1900000
b. Benefits over time
			PlaTech 2		Semi Auto
Sales		A	70000000		70000000
Less:
Operational costs
Labor Costs			388960		1313760
Supplies					9500
Electricity			37000		24000
Depreciation			1075000		65000
Total Costs		B	1500960		1412260
Gross Profits		A-B	68499040		68587740
Less:
Loss on sale of automated
machines			140000
Finance costs			123500
Net Profits			68235540		68587740
% on total sales			97%		98%
From above workings it appears the massive investment in PlaTech2 will not be
so encouraging as the profits of semi automated was slightly higher
Workings
Operational costs of semi automated machines
current 6 machines		nos	rate	shift 8 x 2	p/day	p/month	p/year	Labor
workers		24	15	16	5760	100800	1209600
maintenance workers		2	15.5	16	496	8680	104160	1313760
supplies							9500
electricity							24000
PlaTech 2 Costs		nos	rate	shift 8 x 2	p/day	p/month	p/year	Labor
skilled operators		4	21.5	16	1376	24080	288960
contract maintenance							100000	388960
supplies
electricity							37000
Depreciation of PlaTech 2
Cost		2150000
Life		8
Depreciation per year		1075000
Loss on sale of semi automated machines
semi automated			650000
deprn			-260000
Net Written down value			390000
Less: sale value			250000
loss on sale of semi automated			140000
machines
Interest costs
Net cost of Investment on PlaTech 2			1900000
Interest @6.5% p/annum			123500
c. The discount rate is the 6.50% rate at which the company can borrow its loans
The net present value does not warrant the high investments
2. The decision to not go ahead with the proposed huge investment is due to the following
factors
a) The end profit from semi automated machines is still significantly higher when compared to
the profits from PlaTech 2
b) The huge investments will increase the debt percentage of the company which is
already very high at 40%
c) The new machines would mean lay of 24 workmen which may not go well with the
Union and there may be unnecessary legal issues and costs that have not been calculated
in the above workings.
d) With the US economy slow down news all around, it is not in the interests of the company to
change their machines. The current semi automated machines are doing a super job and with
such a low defect rate, the machines it appears are working very efficiently. So there is no
need to change an existing working system as it stands today.
So Michael Roberts must not proceed with the project