Question

Life is messy and deciding how to allocate capital resources is complicated. So, unlike the highly simplified problems used in class (and in the online examples, homework, etc.), this is a more robust capital budgeting decision problem.

Acme Manufacturing, Inc. was originally a family owned operation that has been in business for several generations. It has grown steadily and is now listed on the stock exchange with family members still owning a substantial portion of the shares. Over the years, the company has acquired a reputation for exceptional quality and has won awards from major customers.

The firm is 75% equity financed; shares currently trade at $37 and do not pay a dividend. Debt capital is provided by a single issue of bonds (20 year, $1,000 par value, $85 coupon) currently trading at $1,094. The firm’s beta is 1.25. Their traditional hurdle rate has been 12%, though the rate has not been reviewed in many years. Over the years, shareholders have come to expect a 10% return. Their corporate tax rate is 25%. Treasury securities are yielding 4.75%. The market rate of return on equities
is 8.25%.

They are currently using several old-style machines that together had cost $700,000. Depreciation of $220,000 has already been charged against this total cost; depreciation charges are $80,000 annually. Management believes these machines will need to be replaced after eight more years. They have a current market value of $205,000.

The old machines require eleven workers per shift earning $14.50/hr plus three maintenance workers paid $13.50/hr. The plant operates day and afternoon shifts five days each week; maintenance workers are assigned to the afternoon shift only. Maintenance expenses have been running at $5,500 annually; the cost of electricity has been $26,000 per year. The production process is not only labor intensive, but also physically demanding. Workplace injuries are not uncommon and lately medical claims have been increasing.

The Machine Tool Division is considering the purchase of a piece of highly-automated, robotic production equipment. It would replace older machines and would offer improvements in quality, and some additional capacity for expansion. Because of the magnitude of the proposed expenditure, a careful estimate of the projects costs and benefits is needed.

The new machine will have a total cost that includes shipping, installation and testing of $1.5 million. The plant will also need $350,000 in modifications to accommodate the new machine. These costs will
be capitalized and depreciated over the eight-year estimated life of the machine. The new machine would require only two skilled operators (one per shift) who would earn $25/hr. Maintenance will be outsourced and cost $90,000 per year. The annual cost of electricity is estimated to be $50,000.

Certain aspects of the decision are difficult to quantify. The most obvious is that Management’s relationship with the union hasn’t always been a smooth one and union leadership may not agree to the layoff of the redundant workers. Reassigning them to positions in other divisions might be easierbut there are currently only a handful of suitable openings, some of which are not in the collective bargaining unit.

The specs on the new machine indicate that even higher levels of product quality and lower scrap ratesare possible. In light of ever-increasing competition, this might prove to be of enormous competitive
advantage. The new machine has a maximum capacity 27% higher than the old semi-automated machines which are currently operating at 90% capacity.

Assignment Parts:
a. Calculate the firm’s Weighted Average Cost of Capital.

b. Identify and analyze the relevant cash flows for the two alternatives - buying the new machine vs. continuing to use the old ones.

c. List and describe briefly any areas of uncertainty or concern for this project. What effect might
they have? Bullet points are just fine.

d. Based on your results in parts b & c, explain why you would or would not proceed with the new
machine.

Answer 1

Answer a) Weighted Average Cost of Capital

Particulars	Value	Market Value
Equity weight	75.00%	37.00
Debt weight	25.00%	1,094.00
Debt Maturity Time	20 years
Debt Issue rate (Par Value)	1,000.00
Debt Coupon	85.00
Debt Coupon Rate (Coupon / Par Value)	8.50%
Beta	1.25
Existing Hurdle Rate	12.00%
Shareholder Expected Return	10.00%
Corporate Tax	25.00%
Treasury Security yield	4.75%
Market Rate of Return on Equity	8.25%
Cost of Equity Using Capital Asset Pricing Model (CAPM)	Value
Cost of Equity (CoE)= Rm +B*(Rm - Rf), where
Rm = Market Return
B = Beta of Firm
Rf = Risk free return on treasury
CoE = 8.25% + 1.25*(8.25% - 4.75%)	12.63%
Cost of Debt
Cost of Debt (CoD)= Interest Expense or Coupon Rate*(1 – Corporate Tax Rate)
CoD = 8.50% * (1-25%)	6.38%
Weighted Average Cost of Capital (WACC)
WACC = Equity weight * CoE + Debt weight * CoD	11.06%

Answer b) Cash flow analysis

Particulars	Old Machine	New Machine
Annual Depreciation Charge	-80,000.00
Plant modification charges	-	3,50,000.00
Machine Cost (A)	7,00,000.00	15,00,000.00
Depreciation Charged (B)	-2,20,000.00	-
Machine Book Value as of date (A-B)	4,80,000.00	15,00,000.00
Machine Current Market Value	2,05,000.00	-
8 Year Depreciation (Annual Depreciation Charge) * 8	-6,40,000.00	-
Salvage Value After Eight Years	0	-
Workers Compensation Assuming 4 hours shift each 5 days a week
No. of Workers per shift	11.00	2.00
Rate of compensation per worker per hour	14.50	25.00
Annual workers Payout (No of Workers * Rate * 4 hours * 264 Days * 2 Shift)	3,36,864.00	1,05,600.00
Excel formula	=F12*F13*4*264*2	=G12*G13*4*264*2
No. of Maintainence workers per shift	3.00	-
Rate of compensation per maintainence worker per hour	13.50	-
Annual maintainence workers Payout (No of Workers * Rate * 4 hours * 264 Days * 1 Shift)	42,768.00	-
Excel formula	=F16*F17*4*264	-
Annual maintainence expense	5,500.00	90,000.00
Cost of Electricity annually	26,000.00	50,000.00
Cash Flow
Machine Cost	-	-15,00,000.00
Plant modification charges	-	-3,50,000.00
Workers Cost	-3,36,864.00	-1,05,600.00
Maintainence workers cost	-42,768.00	-
Maintainence Cost	-5,500.00	-90,000.00
Electricity Cost	-26,000.00	-50,000.00
Total Cost	-4,11,132.00	-20,95,600.00
Operational Cost (excluding machine and plant modification charges)	4,11,132.00	9,45,600.00

The total cost for operating the machine/ plant is higher in case of installing the new machine in the plant. The cost of operating the existing structure is at $4.1 million vs the new machine at $9.45 million. If given there are significant increase in revenue (information is missing in the question above), then we could use the Net Present Value formula to calculate the projects value today wherein if the NPV becomes positive by using the new machine, we would go ahead and install the new machine.

Answer c)

1. One of the biggest uncertainty of the project would be Labour Laws and Union stopping the company from have the existing employee resign the company in order for the company to install new machine. As new machine is installed, the company would need to lay off 9 workers from its labor force. Given not so smooth relationship exist between the company's management and labor union, this would first and biggest concern.
2. Cost of installing new machine does not guarantee more revenue or increase in revenue of the company in near or long term, thus if the company is not able to generate more money it may end up in losses, resulting in deeper threats.

Answer d) I would refrain from going ahead the installation of the new machine as it is uncertain the new machine could get more revenues for the company and given it would also face pressure from the labor union, it might not be able to have a smooth transition to robotic machinery. The company should first consider newer options to build revenue streams and then how to support these streams by upgrading its plant.