© 2000 John Petroff

E- Capital budgeting

Automation to increase production and sale volumes is only one - albeit a most important - decision to use funds at firm's disposal. As presented in Chapter 3, such decisions are studied for individual projects as part of capital budgeting. This section demonstrates how capital budgeting decisions are made, and how an outside analyst can judge whether an optimal combination of projects has been chosen. These projects can be classified according to nature of the project and additional risk for the firm:
- new products: higher risk for firm
- expansion of sales of existing product: company average risk
- replacement of equipment: lower risk for firm
Other major decisions are also studied in the context of capital budgeting, such as lease-or-buy.

All these decisions are studied with the help of net present value NPV and internal rate of return IRR methods which were defined and outlined in Chapter 3. Such decisions are naturally worked out by a financial analyst inside the firm. But, as pointed out in the beginning of this chapter, outsiders must be familiar with the methods used. Since a project often requires financing, lenders such as banks or insurance companies, and investors such venture capital firms, investment companies or potential merger partners must be able to assess the consequences of a company's major decisions. However, because of the necessary large volume of projections, the outside analyst will normally rely heavily on unaudited estimates available from the company. An outside analyst has the advantage of being impartial in studying individual projects. But being an outsider, an analyst cannot possibly have the breadth of concerns management has: only management is aware of the large spectrum of opportunities available to the firm. Indeed all the projects must be evaluated in conjunction with one another. The decision must be made on the optimum combination of projects that achieve the largest combined increase in wealth.

To illustrate the evaluation of projects, we look at nine projects of Zee Company. Zee Company is a local bottler of soft drinks in business for 15 years with sales exceeding $ 20 millions and assets of $ 10 millions. In year 2000, Zee Company is facing a tight competition and needs to introduce new products to maintain its sales annual growth of 5%, and improvements in efficiently to remain profitable. Zee Company is a closely held corporation with the owners holding 51% of the shares. The net worth of the company is $5 millions and long term debt amounts to less than $ 1 million. Management has arranged with First Local Bank for a term loan of up to $ 2.5 millions at a rate of 10% for ten years with merely a blanket pledge of its inventory and equipment. Management is reluctant to issue new shares for fear of losing full control of the corporation, and additional borrowing would be at a higher rate and would raise the average cost of capital beyond the current 10%.

The nine projects Zee Company has planned are described below and the annual cash flows are presented in Table T-10.4 below:

- Project 1: A new conveyor belt is essential to prevent interruption in production experienced periodically (once every two or three months) with the old conveyor belt, causing lost sales of over $200,000 annually. The new conveyor belt has an estimated life of 20 years, but after 10 years, management anticipates some interruptions will start to take place. The installation of the new conveyor belt costs $ 1.45 millions. Management estimates that installation of the conveyor belt will reduce sales and profit volatility

- Project 2: An intranet has been planned for sometime. It would speed up customer orders and reduce lost sales (caused by a salesman’s lack of control over inventories and orders). The intranet cost is only $180,000 but it is expected that it will have to be replaced in about twelve years.

- Projects 3, 4 and 5: These are three alternative trucks that must replace one of the trucks in the fleet that no longer runs.Truck 3 is the most reliable and durable truck: it has a 12 year life but costs $60,000. Truck 2 is only half the price, but it is a smaller truck and it has half the useful life (6 years). Truck 1 is a new truck recommended by the dealership because of its low price, and a capacity equivalent to truck 3; moreover, it is used by competitors; but it is known to start breaking down and require significant repairs after a few years of operation. Management has assigned a high level of risk to truck 1. Truck 2 and 3 types are currently in use by Zee Company, and management considers that they have the same risk level as the overall company.

- Project 6: A warehouse in a town 200 miles (300 kms) away has been used as temporary storage when a previous sales expansion plan was adopted three years ago. Sales did not expand as much as planned and the warehouse is now costly and inconvenient, but canceling the lease requires a payment of $35,000. Canceling the lease would however save $10,000 of lease payments in excess of alternative warehousing cost, for the next four and a half years. Moreover, deliveries from the central warehouse would be more efficient and reduce the risk of theft, spoilage and wrong merchandise associated with the small remote warehouse. Closing this warehouse would reduce notably company risk.

- Project 7: This is a standard product promotion with major design, packaging, vending machine replacement and advertisement in the first year at a cost of a half a million dollars, and in the fifth year at a cost of a little more than a quarter million dollars. The risk of this project is practically the same as the bulk of Zee Company current activities, but just slightly higher.

- Project 8: This is a packaged snack, a new product for Zee Company that research and development has already designed, and that market research revealed would be a close complement to the soft drinks distributed by Zee Company in the same market where Zee Company products are well represented. The project requires an initial investment of half a million dollars immediately for production and distribution facilities. Most revenues the first three years will be plowed back into promotion, resulting in very small net cash flows. But, the potential is for the sales to reach half a million of dollars in six years, at which time the continuation of the new product will be reconsidered or expanded. This is a risky project for Zee Company, and a new injection of promotion will be required in the sixth year.

- Project 9: Project 9 is another variation and addition to the proposed packaged snack, but on a larger scale and in new markets. It requires close to one million dollar investment immediately not only for production and distribution, but also for vending machines that would be placed in amusement parks, sports arenas and airports. The investment size mandates that an additional major promotion be undertaken in the fourth year. If sales materialize, it is projected that this could be a regular revenue for the next twenty years. Zee Company realizes that this is a totally new market which is already dominated by two other nation-wide brands. The market is also subject to uncertain cyclical customer traffic patterns characteristic of the recreational and leisure travel sector. Succeeding in this market is expected to be difficult and a high risk factor is assigned to this project.

See review questions Q-10E.1 through Q-10E.4.

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