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) Assuming that the Net Present Value (NPV) of the new plant shows a negative amount.

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.

Comment:As far as depreciation expenses is concerned, it is a non-cash allocation of the cost of the asset , over its useful economic life -years.

So,normally, the effect of depreciation expense is to preserve cash inside the organisation to the extent of depreciation expense * Tax rate , ie.savings in cash outflow for tax expenses.

So, the more, the depreciation amount charged in initial years, the more the present value of tax shields & the more the NPV of these cash flows.

So, double declining balance method of depreciation will actually fetch more depreciation tax shields & hence more NPV.

Therefore,NORMALLY--FOR WITH- TAX PROJECTS--- the NPV value of the project will be improved only under DDB & not under st.line depn. Method.

BUT, in this question, it is given, there is no income tax for the present . In addition depreciation is a non-cash expense---so, it might not have been considered for NPV calculations at all.

DDB or st.line would not have had any effect on the NPV calculated.

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.

Comment:YES. Lower cost of capital, if that can be really achieved, improves the NPV , as the PV of cash in- flows increase, at lesser discount rates.But care should be taken to ensure the cost of finance is accurate. Otherwise, the project will become unprofitable, if any error is committed in this regard.

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:All these intangibles, must already have been reflected in the decreased cost figures for the new machine---

for example,

wages of 200 employees had been reduced to only that for 20 employees---wage expense might have reduced.

Due to automation, output units would have increased--so cost per unit incidence would have reduced.

Shorter manufacturing cycle time would have been reflected in reduced overhead costs incurred during production.

so, the production manager should be convinced that the intangibles referred by him ,will show automatically , in the difference in the levels of expenses incurred before & after the automation as well as production units.

Therefore, this negative NPV figure is only after providing for all that had been referred by the production manager.

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

a. The attitude of the labor union towards management's decision to automate, which will displace so many workers & whether the required no.of workers will be willing to work for the compamy , after their peers have been shown the door-- that too, the management took this step , just because they asked for a rise ,is likely to irritate them more.

b.Is there a market for the doubled capacity output? Or just will end-up in antagonising the work force as well as accumulate unsold inventory?