Sawing Machine Equipment Installation; Sawdust Case Scenario

Introduction

The present report is developed for carrying out the analysis of the case study of Sawdust Ltd planning to install a new sawing machine, the Helix Cut Saw and replacing the existing machineries and equipment. The business leader of Sawdust Company, Joseph McDonald is planning to install the new machine for improving the quality of the products and meeting properly the customer demand. In this context, the report is developed to support the decision-making process of Joseph on the perspective of a business consultant. It provides the arguments both for and against the decision on the basis of the financial aspects. This will help the company to take sound decision for promoting the sustainable growth and development of the company. The financial aspects of the replacement decision to be undertaken by the company will be evaluated through the use capital budgeting technique of scenario analysis. The evaluation of different scenarios is carried out through the use of capital budgeting methods of Internal Rate of Return (IRR), Net Present Value (NPV) and profitability index.

Explanation of Case Scenario

            The present case study depicts a situation of replacement decision to be taken by the business leader of Sawdust Ltd, Joseph McDonald.   Joseph is considering the decision to install the new sawing machine, Helix Cut Saw in its British production facility. The main advantage to be realized by the company through the decision of replacing the existing machinery with the new machine for improving the quality of the timber used in the manufacturing of furniture and thus providing high quality products to the customers. However, the use of smoother timber would cause an increase of about 25% in the selling price of timber. As such, the management of the company is not supporting the decision of replacing the existing machinery as they believe that it would decrease the sale volume. The management is of the belief that they should upgrade the current sawing machine and postpone the installation of the Helix Cut Shaw. On the contrary, Joseph is of the opinion that the new machine would improve operational efficiency and thereby will prove to be profitable in the long-term. Also, the increase in the price of Helix Cut Saw at 5% annually is persuading Joseph to purchase the machine as soon as possible. However, the indifferent business performance and lack of support from the management are the issues of major concern for Joseph. As such, the present report evaluates the feasibility of the replacement decision of Joseph through the use of capital budgeting methods for depicting its potential impact on the business performance. The financial evaluation take into consideration the initial investment, deprecation value of the existing machinery and its remaining useful life, reduction in the operating costs and the sales volume through installing new machine.

Capital Budgeting and Investment Appraisal Method Applied in the Given Scenario

            The feasibility of the replacement decision to be taken by Sawdust Ltd Company is evaluated through the use of capital budgeting techniques. Capital budgeting techniques are used in investment appraisal for determining the feasibility of a new project planned to be undertaken by a business organization such as purchase of new machinery, plant or equipment. It is the process of evaluating the feasibility of long-term investments so that a firm is able to realize profits in the long-tern through the selection of such projects. Thus, the potential profits to be attained through the use of capital budgeting techniques will help in taking decisions whether a firm should invest in the potential project option or not (Brealey, Myers and Marcus, 2007). The capital budgeting techniques used for evaluating the viability of the replacement decision to be undertaken by Sawdust Ltd are net present value (NPV), IRR (Internal Rate of Return) and payback period method.  Net Present Value (NPV) is used to determine the potential profitability of an investment project through calculating the difference between the present value of cash inflows and outflows over a period of time. The method takes into account the concept of time value of money for calculating the net present value of an investment project. On the other hand, IRR (Internal Rate of Return) method is used for assessing the profitability of a project through calculating a discount rate at which the net present value of all cash flows becomes zero. The profitability index also known as profit investment ratio is an effective method used for quantifying the value of projects per unit of investment (Brigham and Michael, 2013).

Use of Scenario Analysis in Replacement Decision

            The replacement decision regarding replacing an existing asset with the new one is taken by the management of company either to increase the revenue or to decrease the operating costs. As such, the present case study analysis has depicted that the decision of Joseph to replace the existing machine with the new sawing machine is taken for reducing the operating costs.           The use of technique of scenario analysis can prove to be an effective method for taking accurate replacement decision by a business manager. The technique helps in determining the net present value of a potential investment through the use of high and low inflation scenarios. As such, the sensitivity of the investment project present before Sawdust is analyzed under different variable scenarios for determining the expected value of a proposal investment under the technique of scenario analysis (Bromwich and Bhimani, 2005).

Scenario Analysis of the Sawdust Scenario using investment appraisal technique

On the basis of given information there is need to make the decision whether to replace the existing sawing machine with the new Helix Cust Saw (New Equipment). There is need to make scenario analysis using the sensitivity technique so that all the changes due to installation of new equipment can be group into scenario 2 (Replacement) and can be compared with the scenario 1 (Existing Equipment). To make the analysis of different scenario in different sensitivity case, capital budgeting methods such as net present value (NPV), internal rate of return (IRR) and profitability index has been calculated. The analysis has been explained in detail below.

Scenario 1: Existing Equipment (Old Sawing Machine)

  • Input and assumptions taken for given scenario 1
Input    
Book Value for existing Equipment  £    1,000,000.00  
Salvage value    
If sold at current year  £         200,000.00  
If sold after 4 years  £                                –    
     
Depreciation Life 4 years
Depreciation per year  £         250,000.00  
     
Sales price In 2008  £                   120.00  
Raw material price in 2008  £                      45.00  
     
Increase in sales price per year 3%  
Increase in raw material cost per year 3%  
     
Selling price in year 2012  £                   135.06  
Raw material cost in cost in year 2012  £                      50.65  
  • Assumptions made in scenario 1
Assumptions    
Cost of Capital 12%  
Tax Rate 30%  
Operating expenses 20% of Sales  
Depreciation Method Straight Line Method  
Same number of units Sold Every Year  
  • Sensitivity of Sales Volume and Operating expenses
Sensitivity
Number of Units Sales
Worst Case 6000 units
Normal Case 8000 units
Best Case 10000 units
Operating expenses
Worst Case  £      400,000.00  
Normal Case  £      300,000.00  
Best Case  £      200,000.00  
Calculation of Selling Price
Year Selling price
2008  £                    120.00
2009  £                    123.60
2010  £                    127.31
2011  £                    131.13
2012  £                    135.06
Calculation of Raw Material Cost
Year Cost
2008  £                       45.00
2009  £                       46.35
2010  £                       47.74
2011  £                       49.17
2012  £                       50.65
  • Calculation of Cash flows and values of NPV, IRR and Profitability Index in Normal, worst and best case in Scenario 1
    • Normal case of scenario 1
  • Worst case of scenario 1
  • Best case of scenario 1

Scenario 1: Replace with Helix Cut Saw (New Sawing Machine)

  • Input and assumptions taken for given scenario
Input    
New Equipment Cost  £         1,500,000.00  
Salvage value Nil  
Saving in Old equipment  £             200,000.00  
     
     
Depreciation Life 10 years
Depreciation per year  £             150,000.00  
     
Sales price In 2008  £                     120.00  
Raw material price in 2008  £                        45.00  
     
Increase in sales price per year 3%  
Increase in raw material cost per year 3%  
     
  No Replace Replace
Selling price in year 2012  £                     135.06  £                 168.83
Raw material cost in cost in year 2012  £                        50.65  £                   50.65
Operating Cost Reduction 0% 15.00%
Reduction in Sales Volume 0% 5%
  • Assumptions made in scenario 2
Assumptions    
Cost of Capital 12%  
Tax Rate 30%  
Operating expenses 20% of Sales  
Depreciation Method Straight Line Method  
Same number of units Sold Every Year  
No Salvage Value at the end of 10 year    
  • Sensitivity of Sales Volume and Operating expenses
Sensitivity
Number of Units Sales
Case No Replace Replace
Worst Case 6000 5700
Normal Case 8000 7600
Best Case 10000 9500
Operating expenses
Case No Replace Replace
Worst Case  £      400,000.00  £      340,000.00
Normal Case  £      300,000.00  £      255,000.00
Best Case  £      200,000.00  £      170,000.00
  • Other Important calculation required for analysis
Calculation of Selling Price
Year Selling price
2008  £              120.00
2009  £              123.60
2010  £              127.31
2011  £              131.13
2012  £              135.06
Calculation of Raw Material Cost
Year Cost
2008  £                45.00
2009  £                46.35
   
2010  £                47.74
2011  £                49.17
2012  £                50.65
Cash Outflow of new Equipment  
   
Cost of New Equipment  £    1,500,000.00
   
Saving in Old equipment  £        200,000.00
Cost of Old Equipment  £    1,000,000.00
   
Loss on Sale  £        800,000.00
Tax Saving  £        240,000.00
   
Cash Outflow of New Machine  £    1,060,000.00
  • Calculation of Cash flows and values of NPV, IRR and Profitability Index in Normal, worst and best case in Scenario 2
    • Normal case of scenario 2
  • Worst case of scenario 2
  • Best case of scenario 2

Discussion of outcomes of from the above scenario analysis

 In this section of the report comparison of scenario 1 (Existing Machine) and scenario 2 (The new machine) has been made on the basis of net present value, IRR and profitability index. The below table reflects the results of the comparison. As in scenario 1 there is no outflow of cash in present period it is possible to calculate the internal rate of return.

Particulars Existing Equipment New Equipment
Case NPV IRR Profitability Index NPV IRR Profitability Index
Best Case  £  3,161,326.48 NA 1.00  £      3,357,964.33 63.35% 4.17
Normal Case  £  2,020,899.57 NA 1.00  £      2,031,044.03 44.54% 2.92
Worst Case  £      880,471.66 NA 1.00  £         704,123.73 24.41% 1.66
Note: As in existing scenario there is no outflow of initial investment therefore no IRR can be estimated

You can clearly see from the above table that in best case where sales is expected to be 10000 units the NPV generated by the new equipment was more the NPV generated through use of old sawing machine. The IRR was excellent in best case scenario with profitability index 4.17 that gives a clear indication that company should replace the machine. Same position has been seen in normal case where sales have been estimated at 8000 units. There has been increased NPV in scenario 2 as compared to scenario 1 and IRR of 44.54%. In worst case scenario the sales has been taken at 6000 units and NPV in scenario 2 (new equipment) was less than the NPV from scenario 1 (existing machine). As the sales volume has only been taken on the basis of assumptions and there is no proper evidence behind the assumptions it is management discretion to chose the sales unit by themselves and make the decisions. In addition to sales volumes, it is also important to look at the operating expenses amount each year as no such details are provided by the management to be considered in analysis and assumptions are used to figure out the operating expenses (Peterson and Fabozzi, 2002).

Recommendations to the management

It is recommended to the management to replace the existing sawing machine with the helix cut machine if the sales volume of the company is above 6000 units and operating expenses is below $300000 without the implementation of new equipment. In normal and best case the NPV of new equipment was more than the old equipment that allows replacing the existing equipment. The NPV was very less in worst case scenario in case of new equipment so it not advised to replace the machine if there is expectation that sales will decrease in future period (Ross, Jaffe, and Kakani, 2008).

References

Brealey, R., Myers, S.C. and Marcus, A.J., 2007. Fundamentals of Corporate Finance. Mc Graw

Brigham, F., and Michael C. 2013. Financial management: Theory & practice. Cengage

Bromwich, M. and Bhimani, A., 2005. Management accounting: Pathways to progress. Cima

Hill, New York.

Learning.

Peterson, P,P and Fabozzi,F,J,. 2002. Capital budgeting: theory and practice. John Wiley & sons.

publishing.

Ross, A., Jaffe, J. and Kakani, R.K. 2008. Corporate Finance. Pearson.

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