Question

Brisbane Automotive manufactures trucks with its plant in Tai Po Industrial Estate. Brisbane employs about 200 workers. Negotiations are currently under way between the management and the labor union to form an agreement that would take effect from 1 January next year. The labor union proposed to have 20% salary increase to the production workers next year. However, the management is concerned that the increase in labor costs will eliminate most or all of its profits. Brisbane’s long-term plans call for expansion of the product line in the near future. Management is working with consultants on a new automated plant that will double present capacity. The estimated cost of the new plant is $15 million. Brisbane adopts double declining balance method for deprecation. When the new plant is to be operational in one year, the existing facility will be sold. The expected sales price of the old facility is $4 million at that time. The production activity in the new plant will be highly automated. If the new facility is undertaken, only 20 production workers will be required, as compared with 200 workers under the existing production system. The management suggests to use Net Present Value (NPV) method to evaluate the proposal of the new plant. Required rate of return is set to be 10%. There is no change in working capital requirement. In addition, Brisbane enjoys a special income tax waiver until 2028 (i.e. no income tax during the period).

REQUIRED:

1) Assume that the Net Present Value (NPV) of the new plant shows a negative amount. It seems that all Directors really buy the idea. Therefore, they have different suggestions with the intention to get a positive NPV:

a. The Marketing Director: We should use straight line depreciation method (instead of double declining balance method) which will generate lower expense. Therefore, the NPV value of the project will be improved.

b. The Design Director: The 10% required rate of return is too high. We should adjust down the required rate of return in order to generate a more favorable NPV result for the project.

c. The Production Director: We should take advantage of this high technology through automation. We should revise our analysis by considering these intangible benefits (such as greater flexibility in the production process, shorter manufacturing cycle times) to make the overall NPV positive.

Comment each of the above three suggestions.

2) Suggest and explain TWO non-quantifiable factors to the management for evaluating the proposal.

Answer 1

1) Assuming that the NPV of the new plant is negative, following are the submissions against each of the views presented:

a) NPV method is applied on the free cash flows available to the firm to calculate the present value of future cash flows. Since depreciation is a non-cash expense, the same is ignored during calculation of NPV of free cash flows.Hence, the Marketing Director's suggestion of using straight line method of depreciation will not impact the negative NPV values.

b) Required Rate of Return is an estimate which is compared against the actual performance. If the NPV itself is negative, the rate of return will not have any correlation in changing it's value. Hence, the Design Director's suggestion of lowering the required rate of return to improve margins is not sustainable.

c) The cost of production is an outcome of the processes followed and amount spent in forming those processes. With automation, the entire production cycle time reduces with using one-tenth of the total manpower required. This will in turn result in overall reduction of operational costs thus improving profits. Hence, the Production Director's suggestion on using advanced technology & automation will contribute in improving profit margins and should be implemented.

2) Two non-quantifiable factors that can be suggested to the management for evaluating proposal are as follows:

Time & Motion Study - This is the study of the steps involved in the entire production cycle. Since every step involves time which has a cost implication, a reduction in step or the time involved will also bring a cost benefit. Hence, time & motion study is quite relevant & beneficial for a large production cycle specially with change in technology.

Lean Process Improvement - It's highly recommended to understand the lean methodology in reducing & eliminating waste in the current process.

Utilisation Report - Additionally, a utilisation report showing the productivity of it's workers is highly beneficial to differentiate between high & low performance workers.