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).

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]

a]

This statement is incorrect. With double declining balance method, a higher amount of depreciation tax shields are realized earlier in the life of the project, which would increase the NPV relative to the straight line method. The NPV using straight line method would be lower than the NPV using double declining balance method.

b]

This statement is incorrect. The required return is calculated based on the different components of capital, their costs and their weights in the capital strucutre. It represents the composite, overall required retun for the firm's investors. It cannot be arbitrarily changed just to improve the NPV

c]

Intangible benefits cannot be included in the NPV analysis. Only those tangible, real cash flow savings should be included in the NPV analysis. If the automation leads to better processes and improved cycle times, the result should be reflected in lower costs or lower working capital investment. Unless these can be expressly quantified, they cannot be included in the NPV analysis.

2]

TWO non-quantifiable factors to the management for evaluating the proposal are :

• The learning obtained from automating this project could be applied to automating future projects and improve their outcomes. This is a long-term benefit and cannot be quantified now.
• Decrease dependence on human labor is an intangible benefit. Human labor is subject to unionization, fatigue, higher errors and other human drawbacks. Automated labor has less errors, does not tire out, and does not form unions. Thus, this is a non-quantifiable long term benefit