Evaluate the following capital expenditure project currently being considered by the management of the BlueScape Company:
BlueScape Company, based in Tasmania, recently learnt about a patented new technology for the production of various forms of woodchip-based sheets used in the furniture manufacturing industry. 60% of the BlueScape’s annual revenue is currently generated by making and selling woodchip-based sheets.
The CEO of BlueScape Ltd firmly believes that the enterprises should invest in capital assets now to ensure that they will be around tomorrow. The director of marketing also believes that the company should invest in latest technology to maintain market share, otherwise “we are going to be bypassed”. On the other hand, the director of finance, who is well aware of the possible financial repurcussions of committing a huge amount of capital in new technology, insists that the new technology, if implemented, should bring in net cash inflows and increase the value of the company.
The BlueScape’s manufacturing process is, at present, semi-automatic. It also takes 4 weeks to process the timber, using natural processes, which are considered environmentally -friendly. The machinery and equipment currently being used on the manufacturing site cost $54,000,000 and has a written down value of $30,000,000. The demand for the products has been fairly stable and output has been maintained at 5, 000, 000 square meters per annum in recent years. It is expected that the demand and output will increase to 6,000,000 square meters if the new technology is adopted.
The accountant of the company has prepared the following data, based on the current level of output , current technology and equipment:
Included in the above overhead expenses is a per unit apportionment of a depreciation charge of $ 7,500,000 per annum. The rest of the fixed overhead expenses are cash expenses and the total fixed overhead expenses will remain the same irrespective of any change in the level of production and sales.
The existing equipment is expected to last for a further four years, and will have no resale (scrap/salvage) value.
The new equipment will cost $67,000,000 and will have an expected life of 4 years. At the end of which it would be sold for an estimated $7,000,000. If the new equipment is purchased now, the old equipment could be sold for $12,000,000 immediately.
The accountant has also prepared the following data to help assess the proposed change.
Included in the above overhead expenses are: (i) per unit apportionment of a depreciation charge of $ 15,000,000 and, (ii) total overhead expense of $1,500,000 (cash-based).
If the new technology is adopted the raw material (timber) inventory can be reduced by $13,000,000. The new technology involves using chemicals, which may be harmful to the environment if not treated properly.
Tasmania has the highest rate of unemployment in Australia and the community is divided as to the desirability of a timber industry in Tasmania.
The appropriate, after tax, cost of capital (discount rate) for the project is considered to be 12%. This is same as the company’s after tax weighted average cost of capital. Assume that the company is subject to 30% corporate tax and that the tax is paid at end of the same year (i.e., not the following year).
The company’s bank is willing to lend the funds required for equipment at a 9% annual interest rate.
What are the techniques available for identifying and evaluating the riskiness of a project? Briefly explain three of such techniques. Perform a sensitivity analysis on NPV of the new project, if the estimates of output and sales, variable costs, reduction in inventory, and applicable discount rate can go up or down by 10%. Identify and comment on the most sensitive variable/s.
Critically evaluate the use of weighted average cost of capital (WACC) of the company, as the hurdle rate for accepting/rejecting the project.
Write your recommendation (with reasons) as an executive summary, which you will present to the CEO. Assume you are the Finance Director.