Financial Theory & Application CASE 10 - AMERICAN PRINTING Case #10: American Pr
ID: 2765886 • Letter: F
Question
Financial Theory & Application CASE 10 - AMERICAN PRINTING
Case #10: American Printing & Embroidery
Capital Budgeting Techniques
American Printing & Embroidery is a mid-size printing business located in San Diego, California which was begun by Colonel Jim Henderson in 1974 after he returned from Vietnam and retired from the U.S. Air Force. Jim’s son Jerry grew up working in the business and, upon his father’s death in 2005, took ownership of the business.
In spite of the overall weakening national demand for printing services, American Printing & Embroidery’s sales continued to grow steadily as a result of Jerry’s tenacious development of new business, coupled with an infectiously positive marketing personality and attention to detail. Ironically, this steady growth in sales has brought Jerry to a point where he must consider four major capital expenditure opportunities:
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Opportunity #1: Facility Expansion
American Printing & Embroidery’s continuous increase in orders has led Jerry to the conclusion that he must either outsource many future printing jobs or expand his facilities to allow for greater storage capacity of specialty papers and inks, and also to allow for a more efficient workflow.
Jerry received two quotes from local construction companies which quoted the job at $1.2 million and $1.28 million. “Those prices were insane!” he said to his friend George in the foyer of his church after the Easter service. George is in the construction business and asked Jerry if he could come by and spec out the job to see if he could improve on those numbers. Jerry was pleasantly surprised when his friend quoted $500,000 for the job. He estimates that if he is able to have this expansion done, he will be able to increase his cash flows by $135,800 per year for Years 1 through 10.
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Opportunity #2: Alternative Facility Expansion
While Jerry and George were playing racquetball early one morning, George told Jerry that he thought of an alternative that would cost the same amount as his first quote ($500,000) but would take advantage of the fact that Jerry’s need for space was “flexible.” In the next three years, Jerry’s greatest need was for workflow improvements, after which his greatest need would be for storage space. George explained how he developed a “flexible wall system” that will allow Jerry to move critical walls when needed with relatively little effort.
This change will alter the cash inflows in such a way that the greater inflows will come in earlier years: $370,000 in Year 1; $270,000 in Year 2; $155,000 in Year 3; and $49,000 in Year 4. After Year 4 there will be no cash inflows.
Obviously, Opportunities 1 and 2 are mutually exclusive.
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Opportunity #3: Invest in a Second Printing Press
If either Opportunity 1 or 2 is accepted, space will be made available to install a second printing press. The cost for a second press will be $1 million and the cash inflows will be $323,460 each year for Years 1 through 10.
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Opportunity #4: Energy Saving Facilities Changes
Jerry had a facilities energy audit conducted recently and quickly discovered that it was obvious that the facilities his father had built in the mid-1970’s were constructed at a time when energy was cheap and there was no thought as to energy efficiency. Thus, the facilities American Printing and Embroidery occupy is a sieve when it came to energy used for heating, cooling, and lighting. Jerry also discovered that the appliances used in the facility were purchased long before anyone had ever heard of Energy Star® rated appliances. He calculated that an investment of $500,000 would allow for the addition of insulation to the ceiling and walls, installation of new triple-pane argon filled windows, energy efficient appliances, and the purchase of a high SEER rated heating and A/C system with insulated ductwork. All of these changes will reduce energy costs by $167,190 each year for years 1 through 5.
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Jerry received his undergraduate degree in business administration and he concentrated in finance when he worked on his MBA five years earlier. Jerry is painfully aware of how the use of debt can lower his average cost of capital, but the potential for a serious decline in income as a result of a possible precipitous fall in demand for printing service has led him to a conclusion that he will not secure any long-term debt unless it is absolutely necessary for his business’ survival. Also, his father was almost pathologically averse to the use of debt. Jerry is not sure why this was, but he suspects that early in the life of the business, his father must have had a very bad experience with debt.
He has been doing some thinking about how he would pay for these capital expenditures without using debt and estimates that he can raise approximately $1.5 million using net income and depreciation (Kr) at a cost of 15 percent. If Jerry needs to secure funds in excess of $1.5 million, he would have to sell some of his own personal securities which are currently earning 21 percent. As a result, in a very real sense, the cost to secure funds in excess of $1.5 million would be 21 percent.
While he is averse to using debt, he has talked to some bankers who have told him that they would be willing to lend him up to $500,000 at a 12 percent rate
Questions:
1. Calculate the payback for each of the four potential investments. Based on the paybacks of the mutually exclusive Opportunities 1 & 2, which would you select?
2. List and briefly explain the advantages and disadvantages of the payback method as a technique for evaluating capital projects.
3. Using both 15 percent and 21 percent discount rates, calculate the net present value (NPV) and internal rate of return (IRR) for each of the four investment opportunities Jerry is considering.
4. Create a bar chart with “%” on the Y axis and “$” on the X axis. On the chart, place each of the four investment opportunities with the highest IRR opportunity on the left and the lowest on the right. The height of each bar will demonstrate the IRR of each project and the width of each bar will represent the amount needed for the initial outlay for each investment opportunity. Superimpose on this chart a line representing the 15 percent discount rate which stair steps up to 21 percent after the $1.5 million point has been reached. Based upon your answers found in Question 3 and the graphic results you achieve in this question, which project(s) would you select and which would you reject? Remember: Opportunities 1 & 2 are mutually exclusive.
5. Create a Net Present Value Profile for the mutually exclusive Opportunities 1 and 2. You may recall from your class discussion that a Net Present Value profile is a graph where NPV is plotted on the Y axis, IRR is plotted on the X axis, and a line is drawn to connect the two points. Superimpose both lines on one graph and determine the approximate % "crossover point.”
6. Using the technique learned in class, determine the exact “crossover point.” What is the significance of this point?
7. After doing all this work, Jerry discovered that he made a major blunder in calculating the cash inflows for investment opportunity 4 (Energy Saving Facilities Changes). He included only the $167,190 in annual energy savings but failed to add to that number the $18,760 in annual depreciation expense he would realize for each of the five years that would come from the purchase of the new HVAC equipment. Recompute the payback, NPV, and IRR for this opportunity and redraw the chart requested in Question 3. Does this change in cash flow alter your recommendation?
Explanation / Answer
Answer 3 Opportunity 1 Calculation of NPV Year Cash flow Discounting factor @15% Present Value of Cashflow (Discounted @15%) 0 -500000 1 -500000 1 to 10 135800 5.01877 681549 181549 Calculation of IRR 1 In the absense of information regarding Tax, it is to be assumed that projects are not falling under tax regime. 2 For calculation of IRR, NPV of the project is 0. 3 NPV = Present Value of Cashoutflow - Present Value of CashInflow 0 = 500000 - 135800 (1+IRR)10 500000 = 135800 (1+IRR)10 (1+IRR)10 = 3.681885125 Refering to the Kimmel Table IRR=24% Calculation of Payback Year Net Cash inflow Payback 0 - 500,000 - 1 138,500 138,500 2 138,500 277,000 3 138,500 415,500 4 138,500 554,000 5 138,500 692,500 Payback period = between 3 and 4 years = 500000-415500 138500 = 0.610108303 i.e. 7 months Payback period= 3 yrs and 7 months Opportunity 2 Calculation of NPV Year Cash flow Discounting factor @15% Present Value of Cashflow (Discounted @15%) 0 -500000 1 -500000 1 370000 0.869565217 321739 2 270000 0.756143667 204159 3 155000 0.657516232 101915 4 49000 0.571753246 28016 155829 Calculation of IRR 1 In the absense of information regarding Tax, it is to be assumed that projects are not falling under tax regime. 2 For calculation of IRR, NPV of the project is 0. 3 NPV = Present Value of Cashoutflow - Present Value of CashInflow 0 = 500000 - 370000 - 270000 - 155000 - 49000 (1+IRR)1 (1+IRR)2 (1+IRR)3 (1+IRR)4 Using trial and error method IRR=35% Calculation of Payback Year Net Cash inflow Payback 0 - 500,000 - 1 370000 370,000 2 270000 640,000 3 155000 795,000 4 49000 844,000 Payback period = between 2 and 3 years = 500000-370000 270000 = 0.481481481 i.e. 6 months Payback period= 2 yrs and 6 months Opportunity 3 Calculation of NPV Year Cash flow Discounting factor @15% Present Value of Cashflow (Discounted @15%) 0 -1000000 1 -1000000 1 to 10 323460 5.01877 1623371 623371 Calculation of Payback Year Net Cash inflow Payback 0 - 1,000,000 - 1 323,460 323,460 2 323,460 646,920 3 323,460 970,380 4 323,460 1,293,840 5 323,460 1,617,300 Payback period = between 3 and 4 years = 1000000-970380 323460 = 0.0916 i.e. 1 month Payback period= 3 yrs and 1 month Opportunity 4 Calculation of NPV Year Cash flow Discounting factor @21% Present Value of Cashflow (Discounted @21%) 0 -500000 1 -500000 1 to 5 167190 2.925984 489195 -10805 As NPV of the opportunity is negative, payback of the same will be more than 5 yrs. Answer 1 Based on Payback opportunity 2 & 3 will be selected
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