Question

In 2004 David Lee started Lee Manufacturing, a company dedicated to manufacturing simple yet efficient gas barbecues. The barbecues are made of aluminum and stainless steel and are priced at the middle of the market. David’s goal has always been to make a barbecue that cooks great food. This means, good quality parts, simple construction, even heat, no hot or cold spots, and a barbecue that will hold temperature from the lowest setting to the highest setting. David’s motto is “high quality for a fair price”. The company offers four basic grill sizes (models) and several options and accessories that can be added on to each model. Lee’s barbecues have been well received. Revenue and profits have grown steadily.

Based on the recommendation from his sales and marketing department Mr. Lee is considering broadening his product line by adding a new product line of Lee charcoal barbecues. These barbecues would be ideal for those cooks that like that distinct charcoal flavor or the nostalgia of barbecuing the old fashioned way. Mr. Lee has asked his sales and marketing team to come up with a sales forecast for units and pricing. He has also asked his manufacturing team to come up with alternatives for the production of the charcoal barbecues including what equipment is needed and what the projected costs would be.

The sales and marketing team hired Advanced Marketing Consultants to conduct a market survey. The total cost for this consulting was $37,500. The initial model would be a mid-sized kettle barbecue. Eventually, two more models would be added, a smaller version ideal for camping or apartment patios and a larger model for the serious cooks.

Based on the survey and their own experience the sales and marketing team has provided a sales forecast. The suggested price of the initial barbecue is $46.90 per barbecue. They would be sold to retailers with a suggested retail price of $69.95. This would provide retailers with a target margin of 33%. The barbecues would be sold by the company’s existing sales force to its existing customer base. Unit sales are forecast at 2,500 in year 1, 5,000 in year 2, 6,500 in year 3, 8,000 in year 4, and then increasing by 1,000 each year thereafter. Sales and marketing expenses are expected to be 10% of total revenue.

The production team forecasts that the fixed costs needed for the charcoal barbecue production line will be $65,000 per year. Variable costs for materials (sheet aluminum, grills, handles wheels, etc.) is expected to be $15.50 per unit. The variable labor costs will vary based on what equipment will be purchased.

There are two brands of equipment that could be purchased to manufacture the lids and bowls of the barbecue. The first is made by the Strong Metal Equipment company. The second is made by the Precision Industrial company.

The Strong brand is more expensive, but higher quality and more efficient. It will cost $125,000 plus an additional $9,000 for shipping and installation. The equipment would be depreciated to zero over 5 years using straight line depreciation. It is expected that the equipment would last for 8 years at which time it would be sold then for $27,500. Maintenance of the Strong equipment would cost $5,000 per year. Since the Strong equipment is more efficient the variable labor cost would be $9.00 per barbecue.

The Precision brand is less expensive. It will cost $95,000 plus an additional $8,000 for shipping and installation. The equipment would be depreciated to zero over 5 years using straight line depreciation. It is expected that the equipment would last for 8 years and would then be sold for $22,000. Maintenance of the Precision equipment would cost $8,000 per year. The variable labor cost with the Precision brand equipment would be $9.75 per barbecue.

The increase in working capital (accounts receivable and inventory) is expected to be $35,000 at the beginning of the project and will be the same for both machines. The company’s cost of capital is 14% and its tax rate is 40%. Since Mr. Lee’s production team believes that both brands of equipment will last for eight years David wants this analyzed as an eight year project.

David has always believed in buying quality so he is leaning towards the Strong brand equipment. But after hearing that you have learned about capital budgeting in your Finance class at UVU he wants to take advantage of your expertise. David has asked you to analyze his choices and give him some advice on which option would provide the best financial outcome for Lee Manufacturing.

Prepare an analysis and professional report for Mr. Lee. The report should be professionally written and include a letter (single spaced), plus attached schedules. The letter should explain what analytical techniques you are using, why you are using those techniques, what the results show, what you would recommend to Mr. Lee and why. Make sure that the letter is well organized and professionally written. Also make sure that the letter includes the following:

1. The cash flows associated with the different equipment brands for each year of the project.

2. The PB period, Discounted PB, IRR, MIRR, and NPV for the two alternatives.

3. Your recommendation of which brand of equipment should be purchased.

4. Attach to your letter schedules that show your analysis and your work. Ideally you will submit two files. A Word file with your letter and an Excel file with your analysis.

Answer 1

Answer 1:

1) Technique used--NPV:
Both the brands have been analysed using the NPV technique of capital budgeting.
The NPV is the most flawless of all the techniques that are available for capital budgeting and has the following advantages.
*it takes into account the time value of money
*the absolute value of the NPV gives the addition to shareholders' wealth if the alternative is chosen.
2) Discounting of cash flows"
The cash flows have been discounted with 14%, which is the cost of capital of the company.
3) Calculations:
Calculations of the cash flows and the NPV have been made for both the brands separately.
The cash flows have been classified as Initial Investment, Operational cash flows and Terminal cash flows.
The NPV is calculated in the end.
These calculations are shown in Annexure A.
4) Base data:
Base data are the ones provided to me by the marketing and production departments
These are enclosed as Annexure B.
5) Findings:
The NPV of the Strong brand is $41,650 and that of Precision brand $39,780. As the NPV of the Strong brand is
higher it is recommended for purchase.
Annexure A
ANALYSIS FOR STRONG BRAND:
INITIAL INVESMENT
cost of equipment including installation	134000
increase in nwc	35000
	169000
TERMINAL CASH INFLOWS
sale value less tax of 40% (0.60*27500)	16500
release of nwc	35000
	51500
OPERATING CASH FLOWS
	1	2	3	4	5	6	7	8
sales (units)	2500	5000	6500	8000	9000	10000	11000	12000
sales in $ ($46.9 per unit)	117250	234500	304850	375200	422100	469000	515900	562800
costs:
materials ($15.5)	38750	77500	100750	124000	139500	155000	170500	186000
labor ($9)	22500	45000	58500	72000	81000	90000	99000	108000
maintenance	5000	5000	5000	5000	5000	5000	5000	5000
fixed costs	65000	65000	65000	65000	65000	65000	65000	65000
depreciation (134000/5)	26800	26800	26800	26800	26800	0	0	0
sales and marketing expenses (10% of sales)	11725	23450	30485	37520	42210	46900	51590	56280
total costs	169775	242750	286535	330320	359510	361900	391090	420280
income before tax	-52525	-8250	18315	44880	62590	107100	124810	142520
tax at 40%	-21010	-3300	7326	17952	25036	42840	49924	57008
income after tax	-31515	-4950	10989	26928	37554	64260	74886	85512
add: depreciation	26800	26800	26800	26800	26800	0	0	0
yearly operating cash inflows	-4715	21850	37789	53728	64354	64260	74886	85512
NPV
yearly operating cash inflows	-4715	21850	37789	53728	64354	64260	74886	85512
pvif at 14%	0.87719	0.76947	0.67497	0.59208	0.51937	0.45559	0.3996	0.35056
PV	-4136	16813	25506	31811	33424	29276	29924	29977	192596
Sum of PVs of yearly cash inflows	192596
PV of terminal cash flows (51500*0.25056)	18054
PV of cash inflows	210650
Less: Initial investment	169000
NPV of the Strong brand	41650
ANALYSIS FOR PRECISION BRAND:
INITIAL INVESMENT
cost of equipment including installation	103000
increase in nwc	35000
	138000
TERMINAL CASH INFLOWS
sale value less tax of 40% (0.60*22000)	13200
release of nwc	35000
	48200
OPERATING CASH FLOWS
	1	2	3	4	5	6	7	8
sales (units)	2500	5000	6500	8000	9000	10000	11000	12000
sales in $ ($46.9 per unit)	117250	234500	304850	375200	422100	469000	515900	562800
costs:
materials ($15.5)	38750	77500	100750	124000	139500	155000	170500	186000
labor ($9.75)	24375	48750	63375	78000	87750	97500	107250	117000
maintenance	8000	8000	8000	8000	8000	8000	8000	8000
fixed costs	65000	65000	65000	65000	65000	65000	65000	65000
depreciation (103000/5)	20600	20600	20600	20600	20600	0	0	0
sales and marketing expenses (10% of sales)	11725	23450	30485	37520	42210	46900	51590	56280
total costs	168450	243300	288210	333120	363060	372400	402340	432280
income before tax	-51200	-8800	16640	42080	59040	96600	113560	130520
tax at 40%	-20480	-3520	6656	16832	23616	38640	45424	52208
income after tax	-30720	-5280	9984	25248	35424	57960	68136	78312
add: depreciation	20600	20600	20600	20600	20600	0	0	0
yearly operating cash inflows	-10120	15320	30584	45848	56024	57960	68136	78312
NPV
yearly operating cash inflows	-10120	15320	30584	45848	56024	57960	68136	78312
pvif at 14%	0.87719	0.76947	0.67497	0.59208	0.51937	0.45559	0.3996	0.35056
PV	-8877	11788	20643	27146	29097	26406	27227	27453	160883
Sum of PVs of yearly cash inflows	160883
PV of terminal cash flows (48200*0.25056)	16897
PV of cash inflows	177780
Less: Initial investment	138000
NPV of the Precision brand	39780

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