Options For Renewal Or Purchase Of New Craft Machine

Background

Describe about the Lifestyle Furniture.

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

Option 1 – Renew existing machine
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

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
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

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
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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