Options For Renewal Or Purchase Of New Craft Machine

Background

Describe about the Lifestyle Furniture.

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Lifestyle Furniture is one of the leading vendors of hardwood furniture. The Company founder and CEO, Mr Fred Smith has run the company well and it has generated a cumulative sales turnover of over $13 million with profits in excess of $1.75 million till 2015. To continue growth, the company has two choices to make

1. Renew an existing machine which costs $ 135,000 and will be usable for 5 years before being scrapped. Sales are expected to grow @ 13.5 %  pa after the first year sales of $ 800,000. There are costs associated with operations, maintenance, consultant cost and other costs of salary & overheads. Overall, the net cash flow of the option for the 5 years is $ 29,421

2. Buy new craft machine and sell the existing machine. This machine also has a 5 year life. Sales are expected to grow @ 13.5  %  pa after the first year sales of $ 1,000,000. Other costs are generally similar to option 1 with some variation in their magnitude.

The analysis is for the two options of

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  1. Option 1 – Renew existing machine
  2. Option 2 – Buy new machine and scrap existing machine 

Based on the parameters given, the year wise cash flows are as given in the table below. Few points to consider are

  1. For option 1, the renewal cost of $ 135,000 and factoring a scrap value of $ 8,000 can be financed with debt @ 6 % which has an annual payout of $ 30,629
  2. For option 2, the renewal cost of $ 225,000 and factoring a scrap value of $ 25,000 can be financed with debt @ 6 % which has an annual payout of $ 48,979

Profit & Loss – Renew existing machine

Year

1

2

3

4

5

Sales

        800,000

        908,000

       1,030,580

       1,169,708

       1,327,619

Deprn

         ( 27,000 )

         ( 27,000 )

          ( 27,000 )

          ( 27,000 )

          ( 27,000 )

Advertising & Marketing

         ( 30,000 )

         ( 30,000 )

          ( 30,000 )

          ( 30,000 )

          ( 30,000 )

Maintenance Costs

         ( 42,200 )

         ( 42,200 )

          ( 42,200 )

          ( 42,200 )

          ( 42,200 )

Operating costs

         ( 75,000 )

         ( 75,000 )

          ( 75,000 )

          ( 75,000 )

          ( 75,000 )

Profit before tax

        625,800

        733,800

          856,380

          995,508

       1,153,419

Tax

       ( 187,740 )

       ( 220,140 )

        ( 256,914 )

        ( 298,652 )

        ( 346,026 )

Profit after tax

        438,060

        513,660

          599,466

          696,856

          807,393

Cash flow

        465,060

        540,660

          626,466

          723,856

          834,393

Alternative 1

Cash Flows

            

Year

0

1

2

3

4

5

Total

EMI for Renewal cost of existing machine

         ( 30,629 )

         ( 30,629 )

         ( 30,629 )

         ( 30,629 )

         ( 30,629 )

     ( 153,147 )

Consultant cost

         ( 25,000 )

          

       ( 25,000 )

Cash flow from machine

  

        465,060

        540,660

        626,466

        723,856

        834,393

   3,190,435

Advertising & Marketing

         ( 30,000 )

         ( 30,000 )

         ( 30,000 )

         ( 30,000 )

         ( 30,000 )

  

     ( 150,000 )

Maintenance Costs

         ( 42,200 )

         ( 42,200 )

         ( 42,200 )

         ( 42,200 )

         ( 42,200 )

  

     ( 211,000 )

Raw material incremental capital

  

       ( 256,000 )

         ( 34,560 )

         ( 39,226 )

         ( 44,521 )

         ( 50,531 )

Operating costs

  

         ( 75,000 )

         ( 75,000 )

         ( 75,000 )

         ( 75,000 )

         ( 75,000 )

     ( 375,000 )

Other expenses

  

       ( 352,000 )

       ( 352,000 )

       ( 352,000 )

       ( 352,000 )

       ( 352,000 )

  ( 1,760,000 )

Increase in net WC

         ( 15,000 )

          

       ( 15,000 )

Opportunity cost of selling existing machine ( net of tax )

         ( 14,000 )

          

Tax on capital gain  on sale of machinery

        

           ( 2,400 )

         ( 2,400 )

Net Cash flow

       ( 126,200 )

       ( 320,769 )

         ( 23,729 )

          57,411

        149,505

        323,833

        60,050

Cost of capital

17 %

          

Net Present Value

       ( 154,363 )

          

Internal Rate of Return

3 %

          

PI

                0.4

Profit & Loss

Year

1

2

3

4

5

Sales

     1,000,000

     1,135,000

       1,288,225

       1,462,135

       1,659,524

Deprn

         ( 27,000 )

         ( 27,000 )

          ( 27,000 )

          ( 27,000 )

          ( 27,000 )

Advertising & Marketing

         ( 30,000 )

         ( 30,000 )

          ( 30,000 )

          ( 30,000 )

          ( 30,000 )

Maintenance Costs

         ( 38,750 )

         ( 38,750 )

          ( 38,750 )

          ( 38,750 )

          ( 38,750 )

Operating costs

         ( 58,500 )

         ( 58,500 )

          ( 58,500 )

          ( 58,500 )

          ( 58,500 )

Profit before tax

        845,750

        980,750

       1,133,975

       1,307,885

       1,505,274

Tax

       ( 253,725 )

       ( 294,225 )

        ( 340,193 )

        ( 392,366 )

        ( 451,582 )

Profit after tax

        592,025

        686,525

          793,783

          915,520

       1,053,692

Cash flow

        619,025

        713,525

          820,783

          942,520

       1,080,692

Alternative 2

Cash Flows

            

Year

0

1

2

3

4

5

Total

Purchase of new machine

  

         ( 48,979 )

         ( 48,979 )

         ( 48,979 )

         ( 48,979 )

         ( 48,979 )

     ( 244,896 )

Consultant cost

         ( 25,000 )

          

       ( 25,000 )

Installation cost

         ( 20,000 )

          

       ( 20,000 )

Cash flow from machine

  

        619,025

        713,525

        820,783

        942,520

     1,080,692

   4,176,544

Advertising & Marketing

         ( 30,000 )

         ( 30,000 )

         ( 30,000 )

         ( 30,000 )

         ( 30,000 )

  

     ( 150,000 )

Maintenance Costs

         ( 38,750 )

         ( 38,750 )

         ( 38,750 )

         ( 38,750 )

         ( 38,750 )

  

     ( 193,750 )

Raw material incremental capital

  

       ( 320,000 )

         ( 43,200 )

         ( 49,032 )

         ( 55,651 )

         ( 63,164 )

Operating costs

  

         ( 58,500 )

         ( 58,500 )

         ( 58,500 )

         ( 58,500 )

         ( 58,500 )

     ( 292,500 )

Other expenses

  

       ( 345,000 )

       ( 345,000 )

       ( 345,000 )

       ( 345,000 )

       ( 345,000 )

  ( 1,725,000 )

Increase in net WC

         ( 22,000 )

          

       ( 22,000 )

Sale of existing machine

          14,000

          

        14,000

Tax on capital gain

          

           ( 7,500 )

         ( 7,500 )

Net Cash flow

       ( 346,750 )

       ( 222,204 )

        149,096

        250,521

        365,639

        557,548

      753,850

Cost of capital

17 %

          

Net Present Value

        471,973

          

Internal Rate of Return

27 %

          

PI

                3.4

Based on this analysis the Net Present Value for Option 1 @ cost of capital 17 % is negative $ ( 154,363 ). The Internal Rate of Return @ 3 %  is less than the cost of capital. Even the profitability index is less than 1. For option 2, all the parameters of Net Present Value, Internal Rate of Return and PI at $ 471,973, 27 % , 3.4 respectively are favorable. Hence the recommendation is to go ahead with buying new machinery

The Net Present Value and Internal Rate of Return profile table and graph are shown below

 Alt 1

 Alt 2

Net Present Value

       ( 154,363 )

        471,973

Internal Rate of Return

3 %

27 %

Though the Net Present Value is negative for Option 1, the Internal Rate of Return is still positive but substantially lower than the cost of capital. In option 2, Internal Rate of Return being higher than cost of capital, Net Present Value is positive. There is no conflict between Net Present Value and Internal Rate of Return for the two options

Inflation linked Cash flow for Option 1

Profit & Loss

Year

1

2

3

4

5

Sales

        800,000

        908,000

       1,030,580

       1,169,708

       1,327,619

Deprn

         ( 27,000 )

         ( 27,000 )

          ( 27,000 )

          ( 27,000 )

          ( 27,000 )

Advertising & Marketing

         ( 30,000 )

         ( 31,200 )

          ( 32,448 )

          ( 33,746 )

          ( 35,096 )

Maintenance Costs

         ( 42,200 )

         ( 43,466 )

          ( 44,770 )

          ( 46,113 )

          ( 47,496 )

Operating costs

         ( 77,250 )

         ( 79,568 )

          ( 81,955 )

          ( 84,413 )

          ( 86,946 )

Profit before tax

        623,550

        726,767

          844,407

          978,436

       1,131,081

Tax

       ( 187,065 )

       ( 218,030 )

        ( 253,322 )

        ( 293,531 )

        ( 339,324 )

Profit after tax

        436,485

        508,737

          591,085

          684,905

          791,757

Cash flow

        463,485

        535,737

          618,085

          711,905

          818,757

Alternative 1

Cash Flows

            

Year

0

1

2

3

4

5

Total

EMI for Renewal cost of existing machine

         ( 30,629 )

         ( 30,629 )

         ( 30,629 )

         ( 30,629 )

         ( 30,629 )

     ( 153,147 )

Consultant cost

         ( 25,000 )

          

       ( 25,000 )

Cash flow from machine

  

        463,485

        535,737

        618,085

        711,905

        818,757

   3,147,969

Advertising & Marketing

         ( 30,000 )

         ( 31,200 )

         ( 32,448 )

         ( 33,746 )

         ( 35,096 )

  

     ( 162,490 )

Maintenance Costs

         ( 42,200 )

         ( 43,466 )

         ( 44,770 )

         ( 46,113 )

         ( 47,496 )

  

     ( 224,046 )

Raw material incremental capital

  

       ( 256,000 )

         ( 34,560 )

         ( 39,226 )

         ( 44,521 )

         ( 50,531 )

Operating costs

  

         ( 77,250 )

         ( 79,568 )

         ( 81,955 )

         ( 84,413 )

         ( 86,946 )

     ( 410,131 )

Other expenses

  

       ( 364,320 )

       ( 377,071 )

       ( 390,269 )

       ( 403,928 )

       ( 418,066 )

  ( 1,953,654 )

Increase in net WC

         ( 15,000 )

          

       ( 15,000 )

Opportunity cost of selling existing machine ( net of tax )

         ( 14,000 )

          

Tax on capital gain  on sale of machinery

        

           ( 2,400 )

         ( 2,400 )

Net Cash flow

       ( 126,200 )

       ( 339,380 )

         ( 63,309 )

           ( 3,852 )

          65,821

        230,185

     ( 236,735 )

Cost of capital

17 %

          

Net Present Value

       ( 324,807 )

          

Internal Rate of Return

-14 %

          

PI

               ( 1.8 )

Profit & Loss

Year

1

2

3

4

5

Sales

     1,000,000

     1,135,000

       1,288,225

       1,462,135

       1,659,524

Deprn

         ( 27,000 )

         ( 27,000 )

          ( 27,000 )

          ( 27,000 )

          ( 27,000 )

Advertising & Marketing

         ( 30,000 )

         ( 31,200 )

          ( 32,448 )

          ( 33,746 )

          ( 35,096 )

Maintenance Costs

         ( 38,750 )

         ( 39,913 )

          ( 41,110 )

          ( 42,343 )

          ( 43,613 )

Operating costs

         ( 58,500 )

         ( 58,500 )

          ( 58,500 )

          ( 58,500 )

          ( 58,500 )

Profit before tax

        845,750

        978,388

       1,129,167

       1,300,546

       1,495,314

Tax

       ( 253,725 )

       ( 293,516 )

        ( 338,750 )

        ( 390,164 )

        ( 448,594 )

Profit after tax

        592,025

        684,871

          790,417

          910,382

       1,046,720

Cash flow

        619,025

        711,871

          817,417

          937,382

       1,073,720

Alternative 2

Cash Flows

            

Year

0

1

2

3

4

5

Total

Purchase of new machine

  

         ( 48,979 )

         ( 48,979 )

         ( 48,979 )

         ( 48,979 )

         ( 48,979 )

     ( 244,896 )

Consultant cost

         ( 25,000 )

          

       ( 25,000 )

Installation cost

         ( 20,000 )

          

       ( 20,000 )

Cash flow from machine

  

        619,025

        711,871

        817,417

        937,382

     1,073,720

   4,159,416

Advertising & Marketing

         ( 30,000 )

         ( 31,200 )

         ( 32,448 )

         ( 33,746 )

         ( 35,096 )

  

     ( 162,490 )

Maintenance Costs

         ( 38,750 )

         ( 39,913 )

         ( 41,110 )

         ( 42,343 )

         ( 43,613 )

  

     ( 205,729 )

Raw material incremental capital

  

       ( 320,000 )

         ( 43,200 )

         ( 49,032 )

         ( 55,651 )

         ( 63,164 )

Operating costs

  

         ( 58,500 )

         ( 58,500 )

         ( 58,500 )

         ( 58,500 )

         ( 58,500 )

     ( 292,500 )

Other expenses

  

       ( 345,000 )

       ( 345,000 )

       ( 345,000 )

       ( 345,000 )

       ( 345,000 )

  ( 1,725,000 )

Increase in net WC

         ( 22,000 )

          

       ( 22,000 )

Sale of existing machine

          14,000

          

        14,000

Tax on capital gain

          

           ( 7,500 )

         ( 7,500 )

Net Cash flow

       ( 346,750 )

       ( 224,567 )

        142,634

        239,817

        350,543

        550,577

      712,253

Cost of capital

17 %

          

Net Present Value

        431,098

          

Internal Rate of Return

26 %

          

PI

                3.2

Since only Option 2 is feasible, the sensitivity is done on Option 2. Currently, the operations and maintenance cost for Option 2 aggregate $ 97,250 and the project has a positive Net Present Value. In case the expenses rise to $ 148,019 (i.e. an increase of $ 50,769, the project becomes un feasible)

Currently, the sales for the first year are $ 1000,000. In case, the sales drop to $  882,080, the option becomes unfeasible since the Net Present Value is below zero.

Since the borrowing rate is lesser than the cost of capital, it makes sense for the company to lease the new craft machinery. Among lease, the choices are operation lease or finance lease. In operating lease, the ownership of the asset will be with the finance company. Hence depreciation and tax benefits on the same cannot be claimed by Lifestyle. In finance lease, since the ownership of the asset will be with the Lifestyle, they can claim depreciation and tax benefits on the same. The finance company will accordingly adjust the lease rentals to reflect this fact

The company has the following parameters and based on that the Weighted Average Cost of Capital is as under

 Cost

 Book

 Market

Cost of equity

17 %

     1,060,000

     3,000,000

AT cost of debt

6 %

     4,000,000

     3,840,000

Preference Shares

13 %

          40,000

          60,000

Total

  

     5,100,000

     6,900,000

Weighted Equity

  

21 %

43 %

Weighted Debt

  

78 %

56 %

Weighted PS

  

1 %

1 %

Weighted Average Cost of Capital

8.3 %

10.8 %

On book value basis, the weighted debt is 78 %  of the capital mix compared to 56 %  in the case of market method.  This is compensated by the equity and preference share weights. Since the cost of debt is lowest @ 6 %  and the book method gives highest weightage to debt, the Weighted Average Cost of Capital for book method is lower than market method.   

Lifestyle has to cater  to the growth prospects it envisages in future. Based on the analysis above, the recommendation is to buy the new age craft machinery i.e. Option 2 for the following reasons

  1. The Net Present Value, Internal Rate of Return and PI for Option 2 is higher than Option 1 . Net Present Value for Option 1 is negative and hence the option is outright discarded
  2. Even after adjusting for inflation, the conclusion does not change.    

References

“Profitability Index – Complete Guide To Corporate Finance | Investopedia”. Investopedia. N.p., 2012. Web. 30 May 2016.

S, Surbhi. “Difference Between NPV And IRR (With Comparison Chart) – Key Differences”. Key Differences. N.p., 2015. Web. 30 May 2016.

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