Assumptions Used Cash Flow Vulcan Essay Example Pdf - Free Essay Example

Delloyd Engineering Sdn Bhd (Delloyd) specializes in the production of precision metal castings that are components used in the automotive industry. The company is considering automating part of the production process by considering the purchase of the Vulcan Mold Maker, an automated molding machine. The company has proposed to allocate RM 1 Million towards investing into the new molding-machine proposal, and will make a decision on whether to retain the current Semi Automatic Machines or proceed with the investment into the Vulcan Mold Maker. The decision will be based on the net incremental cash flow projected through cash flow forecasts, along with relevant qualitative characteristics and a cost-benefit analysis. 2.0 Assumptions used in preparation of the cash flow for Vulcan Mold Maker and the Semi Automatic Machines Two cash flows have been prepared to project the estimated cash inflow and outflow associated with using the Semi Automatic Machines and the Vulcan Mold Maker for eight years. An eight-year period was chosen for both cash flows as the Vulcan Mold Maker will be fully utilized and depreciated in 8 years time. This is to ensure comparability of the net cash flow for both options available. There are a number of assumptions made and these assumptions serve as the basis for the preparation of the cash flow statement. Firstly, total sales volume need to be determined in order to calculate the cash inflow from sales. The figure used in the cash flow is RM280 million, which equals to the expected sales for calendar-year 2000, provided in the case. It is assumed that the sales figure remains constant over the years for both the machines. This is because the figure is determined by market demand for the moldings and not influenced by the production level of the supplying company. To simpl ify the cash flow presented, factors such as economic downturn and inflation are assumed not to affect the total sales for Delloyd. [NOTE 1] The total cost of goods sold is calculated as a balancing figure by setting the gross profit margin at 35%. The gross profit margin was calculated based on an estimation of the industry average rate. Cost of goods sold consists of direct labour and direct material cost. Direct labour cost for both machines are calculated based on the information given as follows: Vulcan Mold Maker Semi Automatic Machines Number of shift 2 2 Hours per shift 12 12 Days working 210 210 Number of machine operators required 2 12 Labour rate per hour for machine operators RM11.36 RM7.33 Number of maintenance workers required 0 3 Labour rate per hour for maintenance workers RM7.85 Total direct labour cost [NOTE 3] RM 57,254 RM 562,010 Delloyd is currently negotiating a tough collective-bargaining agreement with the employees union regarding the layoff of 24 operators that would no longer be of service should Delloyd choose to purchase the Vulcan Mold Maker. Thus, the cash flow statement for Vulcan Mold Maker is prepared on the basis that the negotiations with the employees union were favourable to Delloyd, without any unforeseeable effects on the companys operations. Information was given in the case that the foundry operated two shifts a day and total of 210 production days in a year. An assumption has been made that the workers work 12 hours each shift as the production process is continuous. The total cost calculated above has been rounded up to the nearest Ringgit. On the other hand, the direct material cost for both machines are calculated by subtracting the direct labour cost calculated above from the total cost of goods sold. It is also assumed that the respective total cost of goods sold will remain c onsistent over the years for both machines as it will not be affected by inflation and economic downturn. [NOTE 2] The calculation of expenses will cover general expenses that cannot be traced directly to the production and is charged on a yearly basis. The expenses for the Vulcan Mold Maker will consist of contract maintenance and power costs. On the other hand, expenses for the Semi Automatic Machines consist of maintenance supplies and power cost. The information on the expenses incurred is provided in the case and assumed to be consistent over the years. [NOTE 4]. Besides, the labour savings that are expected from the use of Vulcan Mold Maker is assumed as a cash inflow, amounting to RM5,200 in the cash flow statement of the new machine. [NOTE 5] The annual depreciation for Semi Automated Machine is RM47,520 and it is provided in the case study. Meanwhile, depreciation for the Vulcan Mold Maker is calculated based on the total cost of investment and depreciated over eight years assuming the straight line method is adopted. Thus, the annual depreciation cost amounts to: Total cost = RM 1.01 m  [1] Useful life = 8 years Annual Depreciation = RM 126,250 [NOTE6] The tax rate used equals to the companys effective tax rate of 43%, which reflected the combination of national and local corporate income-tax rates as given in the case. [NOTE 7] The net capital expenditure in the first year (Y0) for Vulcan Mold Maker is calculated with the assumption that the six Semi Automatic Machines have been sold for the price of RM130,000. The calculation is as follows: Book value of old machines = RM285,125  [2] Capital loss = RM155,125  [3] Net Capital Expenditure = Total cost Offer price Tax savings = RM1,010,000 RM 130,000 (RM155,125 x 43%) = RM813,296 [NOTE 8] The cash flow statement prepared will not include any extraordinary costs that were not mentioned in the case study to ease the comparability purpose. In addition, the consideration of purchase of the Vulcan Mold Maker was decided as the best option after careful consideration of all available molding-machine proposals. This option is assumed to be the most suitable and beneficial choice for Delloyd after a detailed analysis on all of the proposals. 3.0 Cash Flow Statement 3.1 Vulcan Mold Maker 3.2 Semi Automated Machine 4.0 Discount Rate Cost of Equity = Risk-free premium + (Beta) Risk Premium = 5% + (1.25) 6% = 12.5% WACC = % Equity (Cost of Equity) + % Debt (Cost of Debt)(1-Corporate Tax Rate) = 67%(12.5%) + 33% (6.8%) (1-0.43) = 8.375% + 1.279% = 9.654% The Weighted Average Cost of Capital (WACC) for Delloyd is 9.65%. This percentage was calculated by multiplying the cost of each capital by its weight and then adding the two. The weight of debt was given as 33%. The cost of debt given was 6.8%. This number was based on the interest rate of loans to the company from Bank Pembangunan. The corporate tax rate for Delloyd is 43%. The weight of equity was given as 67%. The cost of equity used was 12.5%. This number was calculated by multiplying the companys beta of 1.25 by the equity risk premium of 6% and adding it to the risk free return of 5.0%. The beta, equity risk premium and risk free return were given in the case. The reason for WACC to be chosen as the discount rate is that in actual f act, it is an equally weighted combination of the  cost of equity  and the after-tax cost of debt. It will thus provide the company with information regarding the best financing method whether via equity or debt, or the different combinations of both, that result in a lower cost of capital (Value Based Management.net, 2010). The WACC is then used as the discount rate to discount the net incremental cash follow. The net incremental cash flow is calculated by subtracting free cash flow of the Semi Automatic Machines from the free cash flow of Vulcan Mold Maker for the eight years. The calculation results in a negative NPV, which means that the investment in the new machine should be rejected. Only projects that yield a positive NPV will be regarded as a good investment decision (Michel, 2001). It was provided in the case study that the inflation rate is 3%. This rate was not incorporated in the calculated cash flow and NPV. However, if this has been taken into acco unt, it would have been resulted in a lower NPV because discount rate will increase. This is in accordance with Fishers Equation Theory which presents that nominal interest rate has to increase so that the borrowers can achieve their real interest rate. The lower NPV further reduces the attractiveness of the investment if it was financed by loans (Sun Phillips, n.d.). 5.0 Calculation of net incremental cash flow to NPV 6.0 Impact on the discount rate for two different financing methods Delloyd has two different options to finance the acquisition of the Vulcan Mold Maker. Delloyd can either take up a loan or issue additional shares in order to raise capital to fund the acquisition. The current market value of the companys capital is made out of 33% debt and 67% equity. Hence, the effect on the discount rate is further analyzed in two separate situations below, where the company chooses debt or equity financing. The WACC is calculated with the assumption that all other factors, other than the debt and equity percentages, will remain consistent. Situation 1-The company takes up a loan to finance acquisition. Effect : Composition of 60% debt and 40% equity = 40% (12.5%) + 60% (6.8%) (1-0.43) = 7.326% The discount rate drops when the company relies on more debt. Cost of debt is comparatively lower than cost of equity. This is because of the pecking order theory, whereby companies have a specific hierarchy when it comes to selection of financing methods. New debt is preferred over issue of new external equity due to lower transaction costs (Emery, Finnerty Stowe, 2007). Tax shields provided by debt financing also leads to a decrease in WACC as interest payments are tax-deductible. Besides that, debt financing also involves the use of company asset as security to the loan, as well as restrictive loan covenants set by the lenders to ensure that Delloyd would use the loan strictly for a proper purpose (Anderson, 2000). Hence, the WACC value is generally lower to reflect lower risk. A lower WACC would result in a maximization of the firm value. When the company decides to take up additional loans, this would indicate the company is now relying more on borrowed funds. Debt financing will lead to additional obligations of meeting interest and capital repayment (Anderson, 2000). Although these obligations may have a negative impact on the cash flow, this could motive management to work towards earning more profits in order for the company to meet these monthly obligations. Delloyd must reconsider taking up debt financing because if the company plans to use additional debt financing in the future, banks might be more reluctant to provide loans. A higher reliance on debt to finance assets indicates that Delloyd is at a higher risk of being unable to repay loans. This may result in higher interest rate charges in the future. Situation 2-The company issues additional shares to finance purchase of Mold Maker Effect : Composition of 20% debt, 80% equity = 80% (12.5%) + 20% (6.8%) (1-0.43) = 10.78% The WACC increases when the company relies on more equity. The issue of additional shares will lead to a dilution in ownership for existing shareholders, and this usually leads to a negative market reaction in the initial stage (Liesz, 2001). Equity financing will also involve transaction costs, including administrative and underwriting costs and this will have an impact on the WACC (Myers, 1984). In addition, when a company becomes liquidated, the shareholders will only be able to claim the residual assets after all debt obligations have been met. Hence, shareholders bear the highest risk and hence, must be compensated with relatively higher returns. The WACC will increase as a result, to reflect a higher risk associated in relying on equity financing. 7.0 Qualitative Issues Important decisions should not be made based on quantitative considerations alone. There are also qualitative issues related to the purchase consideration which are important and relevant to this capital investment decision. One of the most pressing issues faced by Delloyd is the ongoing negotiations with the employees union. This external stakeholder has the power to influence the reputation of the company should the union become dissatisfied with the outcome. Delloyd could easily be portrayed as a company that does not value the contributions of their employees. The layoff may adversely affect employee morale within the company. The other employees may suffer from survivors guilt, a term used to describe the feelings of surviving employees post layoff period. They feel that their job security has weaken or become angry if they feel that the layoff was injustice. This may potentially affect employee productivity (Brockner et al, 1986). This is supported by Brockner (1992), who goes on to say that proper management of layoffs can occur as survivors reaction can be influenced by upper management. Although Delloyd considered reassignment of the 24 workers to fill up vacant positions within the company, the only available positions were for the post of janitors, who were paid RM 4.13 hourly. The company could offer these positions to the workers that are interested in continuing to work for Delloyd. Managing Director Debbie Lee believes that the quality of the metal castings would increase resulting from the purchase of the Vulcan Mold Maker. Consequently, the scrap rate will reduce leading to fewer rejections of metal castings. The purchase of the Vulcan Mold Maker would allow Delloyd to enjoy a competitive advantage in this aspect. A comparatively lower rejection rate will show potential customers that Delloyd emphasizes on product quality. However, it is difficult to quantify competitive advantage in the cash flow statement and thus, the statement will not reflect this aspect. The purchase of the Mold Maker will also lead to an increase in supply due to a higher theoretical maximum capacity. The increase in supply does not necessarily correspond to an increase in demand. The company becomes more efficient in meeting current demands quickly, but an increase in demand will occur due to external factors beyond the controls of Delloyd. The economy is predicted to slow down, and this will affect the demand for metal castings. It is difficult to quantify this factor as there is no certainty of the future economy condition. However, the company had survived the 1997 financial crisis and could estimate the impact of the current slowdown based on previous experience in preparing the cash flow during the last financial crisis. Another factor to consider is the approval of the Board of Directors (BOD) to purchase the Vulcan Mold Maker. They have already rejected three proposals of similar mold maker and the latest being in 1999 due to economic downturn. As economic downturn is predicted to occur again, it will not be an easy task to get the approval. In addition, the total cost of RM1.01 million has exceeded the proposed expenditure slightly. The BOD also may question the need for extra capacity for the company as the existing machine itself is not running in full capacity. 8.0 Cost benefit analysis As we have looked into the cash flow for the two options and also the other qualitative factors, we can now summarise the cost and benefits of both options. 8.1 Semi Automatic Machine One of the benefits of not replacing the Semi Automatic Machines is that the company does not need to change their way of operating. Change is a word that most people fear because it requires them to move out of their comfort zone. If the company decides to remain status quo, they can comfortably produce their product without new surprises. Of course, this is not always a good option. Not changing into something better often comes with a cost. The company will not be able to progress further and achieving greater heights would be difficult. In addition, the Semi Automatic machines involve more labour costs as it requires more workers to operate the machine. Hence, this will increase the expenses and subsequently, lead to a decrease in NPV. This is due to an emphasis on quality in the metal castings produced. The acquisition of the mold maker would have lead to a drop in rejection rate, but if the company choose to maintain with the use of the Semi Automatic Machine, the scrap ra te would be maintained at 70 parts per million. They would have to forgo the benefits in the form of a reduction in scrap rate. 8.2 Vulcan Mold Maker If the company decides to replace the Semi Automatic Machines with the new Vulcan Mold Maker machine, the company will be able to produce higher quality products. This is an important factor if the company wants to retain its existing customers and also to attract new ones. According to a marketing website, people often buy products that are value for money and not just cheap products (Ali, 2007). By producing higher quality products, it is highly definite that the company is going to be more profitable. Also, the company is able to cut material costs because the Vulcan Mold Maker will result in lower raw material scrap rates. Besides that, the Vulcan Mold Maker requires only 2 workers to operate. Therefore, there will be a substantial amount of labour cost saved as less training and retraining costs will be incurred. The lower number of workers also helps the company to avoid any problems from the employees union which can be a cost to the company in the future. When the Vulcan Mold Maker is purchased, it will decrease the medical claims. The medical claims have doubled since 1998 as there was higher demand on employees to lift heavy objects. It is expected that the demand to lift heavy objects will decrease with the purchase of the new machine. Although it is unquantifiable at this point, there should be a decrease in medical claims leading to a saving in insurance costs. However, if the company decides to put the new machine in place, the company will have to deal with the tough collective bargaining agreement with the employees union before we are able to lay-off the existing workers. The company might need to offer monetary compensation or may provide early retirement benefits to those workers that are affected. These are necessary as the workers may find it difficult to obtain another job as economy is heading downwards. 9.0 Recommendation Although it seems like the benefit of investing in the new machine outweighs the benefit of using the existing machine, Delloyd is advised to maintain its current use of the semi-automatic machines. This is because investing in the new machine will result in negative NPV of the incremental cash flow, reflecting an investment that is not viable. The rule of thumb in investing in a project is that the project must generate a positive NPV. However, Delloyd may want to invest in the new machine in the future when there is an increase in sales and when the economy is stable given the benefits that the company will reap. For the time being, we will advise Delloyd to remain status quo. 10.0 Conclusion Delloyd should not invest in the new machine because it results in negative net incremental cash flow, which is the main consideration in making the investment decision. Qualitative factors were also taken into account when deciding the best option for Delloyd. The NPV of the Semi Automatic Machines is higher than the NPV for the Vulcan Mold Maker. This implies that the current machines will increase the value of the overall company in the future. The ongoing negotiation with the employees union is another main factor. Delloyd has not come up with any solutions other than the layoff. With the recommendations, the 24 workers will be continually employed and this allows Delloyd to maintain a good relationship with the union. Besides that, excess capacity exceeding the current 90% might not be useful for Delloyd as the economic downturn is due to occur. The current scrap rate is relatively low and should not be of concern for now. Hence, the company should focus their efforts towards preparing for the economic slowdown that may occur in the near future. (2960 words)