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Capital Budgeting Financial Evaluation: JBMW

Corporate Finance

Jones Brothers Marble Works (JBMW) 

Owen, Edward, Charles and Daniel inherited a small family business from their parents John and Mary Jones in 2013 and changed its name from Jones and Sons to Jones Brothers Marble Works (JBMW). The business produces high-quality natural stone tiles from limestone, marble and travertine and is located in Brisbane. The beauty of their natural stone product is unmatched and suits all tastes and budgets. Although their products are limited to indoor floor tiling the business has recently grown and has become extremely profitable. Limestone tiles are the stone of choice for elegant projects — the soft look and smooth feeling surface is the main reason for the popularity of this material. Marble is formed from Limestone through a heat process and when it contains limestone it is yellow, and green if it contains serpentine and red if it contains haematite. Marble is ageless and has been used for thousands of years due to its natural beauty and its strength and resistance to fire and erosion and is used for interior flooring and paving fireplaces and staircases. Travertine, has been used in building since ancient times and its warmth and classic simplicity makes it suitable for use in all rooms.

Since 2013 JBMW has expanded and is now located on one of two adjoining blocks owned by the business. The other block remains vacant. Owen, the major shareholder (40%) and Managing Director, believes that the market for indoor floor tiling is saturated and informed his brothers that it was time for JBMW to diversify into other products. He said it was time they made use of the vacant land. He had commissioned Edward the Sales and Marketing manager to look into the feasibility of diversification. Charles, the Production Manager agreed with Owen whereas Daniel the Accountant was not confident about the expansion and preferred the alternative of selling the vacant land which is not depreciable and CGT is not applicable as it was purchased before the introduction of CGT. He had recently received an offer of $350,000 for this valuable piece of land. The maintenance cost of the vacant block is currently $30,000, with costs increasing at a rate of 3 % per annum. However, after some discussion Daniel was persuaded by Owen that now was not the time to sell as land prices were rising in Brisbane and projected to double in 10 years' time according to market forecasts.

Edward had been approached by a Hotel Chain to renovate their Hotels, not just their interior flooring but also their bathroom basins, vanity tops and walls and kitchen table, countertops and walls using Travertine and Marble. The Hotel project was expected to be completed in 3 years and would bring in revenue and enhance their reputation as well while they diversified into the new interior product lines listed above within their current markets in Queensland. Edward also believed that once the Hotel Project was completed they should expand their product range further to cover external paving and tumbled tiles in travertine, marble and limestone for paving around swimming pools. He. had commissioned a market report for 575,000 from a Consultancy firm and together with Charles and the Consultancy firm had projected Sales Revenue as follows. The Internal diversification is expected to generate Sales Revenue of $100,000 in year 1, $150,000 in year 2 and $250,000 in year 3. From then on it is expected to generate Sales of $600,000 each year. On a recent visit to Italy Edward had seen beautiful garden pots in travertine and marble which he believed would add value to their external range. Production of these pots were added as an afterthought to the external range after the market report was completed. The External range is expected to generate $300,000 per year and in addition the Pots are expected to generate Sales revenue of $50,000 per year To get both the internal and external projects off the ground E$25,000 per dward estimyear ated and at a that an advertising campaign would have to be run in the first 3 years at  reduced budget of $20,000 per year in subsequent years. Owen was impressed with the plans that Edward with co-operation from Charles had come at up with in a short time As the space in the current factory was limited Charles suggested th ed new building to accommodate the the vacant block should be used for a fully equipp  additional production. Daniel was much more reluctant to give it the green light. He stated that there were other costs to estimate like the need for additional staff, financing for the new building and equipment and additional need for inventory and so on. Daniel stated he would have to prepare detailed costings before agreeing as he was worried about the additional expenditure and risk associated with this venture. He said that Charles should also make sure he had identified all the costs associated with this venture because if the company went ahead Charles would have to manage all the new business and make sure it was a success. They all agreed to meet the following Monday giving time for Daniel to gather all the required additional information to evaluate the project.
Additional Information:
1. Daniel decided that the projections should cover a 10-year period and should be completed in constant dollars as inflation was not expected to be significant. Based on the expected market return for such risky projects he also decided that the project should achieve a real rate of return of 20%. 

2. The administration costs were expected to increase by $15,000 per annum with the introduction of the internal diversified range and the Hotel Project and is not expected to decrease when the Hotel project ceases as Sales of the new internal range would increase. Introducing the External range would increase the administration costs by $10,000 and by a further $5,000 when Pots are added to the production line.

3. He also estimated that the additional inventory costing $30,000 would be required at the start of the project. Raw materials were estimated at 30% of sales for all goods while factory expenses are estimated at 10% of Sales for the Internal range and the hotel renovation project. The factory expenses are estimated at 20% of sales for both the external range and the Pots.

4. Increased wage costs are estimated at $120,000 for the first 3 years increasing by 4 $8)' 000 from year 4 onwards to cover the external range. $60,000 of this increase frorriyear 4 onwards relates to additional labour costs for the production of Pots. 

5. Daniel plans to estimate as a minimum the NPV, IRR and a payback period for the project. 

6. Daniel was a little concerned regarding the depth of the market research to support the proposed diversification and the extension due to the short time in which it had been conducted. He was more confident regarding the Hotel Chain project as all JBMW had to do was deliver according to a contract for revenues of $600, 000, in each of the 3 years. 

7. Daniel estimated that the new Equipment which would cost $70,000 could be depreciated over 7 years with a scrap value of $3,500 at the end of 10 years even though according to Charles the equipment was very robust and would last for more than ten years. The new building would cost $140,000 and would be depreciated at 7% per annum on a straight line basis. The building was expected to add little value on the sale of the land and therefore written down to zero value in 10 years. 

8. The company pays tax at a rate of 30%. 

9. Daniel had negotiated an interest only loan that would cost JBMW on average $18,000 a year in interest charges over the 10 years to fund the expansion. At the end of 10 years the loan would be fully paid up from internal funds.
Required: As friends of Daniel you have been asked to assist him in the preparation of a recommendation. You are to prepare the following:
1. An executive report making a firm recommendation (accept/reject) the planned expansions. The executive summary must contain concise reasons for your recommendation and a summary of your financial analysis. (Maximum 1000 words) (12 font) (6 Marks). 

2. Readable spreadsheets clearly showing at least the minimum financial analysis required by the accountant as detailed in point 3 above. You should also address the sensitivity of the project to his concerns and any additional analysis if you believe it supports your recommendation. (10 Marks). 

3. Other factors the firm should consider. Here you should be able to specify any further factors the company might have overlooked or other factors that should have been taken into consideration. (maximum 500 words) (12 font) (4 Marks).

Answer

1.Executive Report 

The Jones Brothers marble works is currently in the search for undertaking expansion and building new profits and revenue generating assets to take advantage of the opportunities available in the market. They have opportunities to expend in the same line of business or they can also consider expanding into other sectors for diversification and grow market elsewhere in some other sectors. Current l the company has no cash flow issues and the current business is running well and this is the right time to expand into new business opportunities and establish new lines of revenue generation.

The capital budgeting and financial evaluation of the project has been done as per the followings and the same is shown here below:

  1. The estimation of the Pay back period (PBP) is shown as follows:

cash flow
cum Cash Flow
0
-240,000
-240,000
1
130,950
-109,050
2
162,450
53,400
3
225,450
278,850
4
407,450
686,300
5
407,450
1,093,750
6
407,450
1,501,200
7
407,450
1,908,650
8
404,600
2,313,250
9
404,600
2,717,850
10
438,100
3,155,950


Payback period = 1 Year + (109,050/162,450) = 1+ .67128 = 1.67128

Recommendation 

This means the project would be able to recover all the initial investments in about 1.67 years and thus this shows a profitable investing opportunity for the Jones brother marble works. 

  1. The Estimation of the Net present Value (NPV) is done as follows:

0
1
2
3
4
5
6
7
8
9
10
initial Investment - building 
-140,000










initial Investment - Equipment 
-70,000










Working Capital -inventory 
-30,000










Revenue -hotel 

100,000
150,000
250,000
600,000
600,000
600,000
600,000
600,000
600,000
600,000
Revenue-External Range 

300,000
300,000
300,000
300,000
300,000
300,000
300,000
300,000
300,000
300,000
Revenue -Pots

50,000
50,000
50,000
50,000
50,000
50,000
50,000
50,000
50,000
50,000
Total Revenue 

450,000
500,000
600,000
950,000
950,000
950,000
950,000
950,000
950,000
950,000
less:











Administrative costs 

30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
Factory Expenses -internal 

10,000
15,000
25,000
60,000
60,000
60,000
60,000
60,000
60,000
60,000
Factory Expenses -pots /external 

70,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
Advertising Expenses

25,000
25,000
25,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
increased wages 

120,000
120,000
120,000
180,000
180,000
180,000
180,000
180,000
180,000
180,000
Depreciation- Equipment 

9,500
9,500
9,500
9,500
9,500
9,500
9,500
0
0
0
Depreciation - Building 

14,000
14,000
14,000
14,000
14,000
14,000
14,000
14,000
14,000
14,000
interest Expenses 

18,000
18,000
18,000
18,000
18,000
18,000
18,000
18,000
18,000
18,000
total Expenses 

296,500
301,500
311,500
401,500
401,500
401,500
401,500
392,000
392,000
392,000
Profit Before tax 

153,500
198,500
288,500
548,500
548,500
548,500
548,500
558,000
558,000
558,000
less: Tax @ 30%

46,050
59,550
86,550
164,550
164,550
164,550
164,550
167,400
167,400
167,400
Profit After Taxes

107,450
138,950
201,950
383,950
383,950
383,950
383,950
390,600
390,600
390,600
+Depreciation (building/Equip)
23,500
23,500
23,500
23,500
23,500
23,500
23,500
14,000
14,000
14,000
Scrap Realized 










3,500
Inventory Realized 










30,000
Cash Flows 
-240,000
130,950
162,450
225,450
407,450
407,450
407,450
407,450
404,600
404,600
438,100
Present Value factor @ 20%
1.000
0.833
0.694
0.579
0.482
0.402
0.335
0.279
0.233
0.194
0.162
Present Value @ 20%
-240,000
109,125
112,813
130,469
196,494
163,745
136,454
113,712
94,097
78,414
70,756
NPV
966,078










Recommendation 

As can be seen from the above estimation the NPV of the project is a positive NPV at $966,078 after discounting the cash flows at 20% rate of return. This means if the Jones broths marbles works implements this project the present value or market value of the company would be expected to improve by $966,078. Thus it is recommended to the management of the firm to undertake the project without an further delay as the opportunity might be diluted by some others working in the market and taking advantage. 

  1. The Estimation of the Internal Rate of Return (IRR) is done as follows:

The IRR of a project is a rate of return which would make the net present value equal to zero if discounted at the IRR. This means the rate of discounting to be used would be IRR. As the 20% rate fixed by the jone’s brother company is yielding a positive NPV the same is on the lower side than the IRR. For a decision making purpose if the company finds the IRR to be higher than r , the project would be recommended for investment by the company and if the company finds the IRR to be lower than the r , the project would be rejected (BERK & DEMARZO, 2016). 

The IRR of the current project is found to be 81.90%

Thus, the project is recommended for investment for the following reasons:

  1. The IRR > r (81.90% > 20%), which means the actual return form the investing is expected to generate a return of and the same is much higher than 20% return generally expected by the management. 
  2. As the investment is expected to generate a higher return than what is expected by the management the same is given a go ahead as the same would add value for the firms shareholders (Eugene Brigham & Michael Ehrhardt, 2010). 

Conclusion

Considering the three different criteria’s the project is given a go-ahead as follows:

  1. The payback period of the project which is currently 1.67 years is much lower than the projects life period and thus the project would be expected not to face an cash flow recovery issue. 
  2. The NPV of the project  is positive at $966,078 and the same would increase the market value of the company by $966,078.
  3. The project would also be expected to increase shareholders wealth as the projects IRR is greater than r.
  4. Thus all the financial evaluation method aggress on the implementability of the project and the same would improve the firms value (Damodaran, 2012). 

Assumptions 

For the estimation of the both internal and external project the following assumptions ha been used:

  1. The Research cost of $75,000 paid is ignored as it is not related to the project and is merely a sunk cost. 
  2. Further the Building has been depreciated over the 10 years period ad as a result of which rate of depreciation used is 10%. (100/10).
  3. Equipment’s have been depreciated in 7 years after taking into consideration the scrap value of $3,500 in the tenth year. 
  4. The value of the land used is not used as the land is not depreciable and after 10 ears of use the same can be sold at a higher value and hence it has no opportunity cost of being used. 

2& 3. Sensitivity Report and other factors which the Firm shall consider 

The current project being considered by the management of the Jones brothers marble works is quite profitable and from the above estimations it becomes clear that if the project is implemented without delay the same is expected to add quite large value to the shareholders wealth and increase market value and increase the product portfolio of the company. Form sensitivity point of view the project is quite good:

  1. The payback period of the firm is 1.67 years only. This means the cash invested in the project would be expected to be recovered in less than 2 years. This is particularly pleasing as the firm is taking a minimum 10 years of project life. Thus even if the cash flows are slightly revised (both downwards and upwards) there would not be a fear of not recovering the initial investment made in the project (Brearly, 2012). 
  2. The NPV of the Project being considered in too large at $966,078 ad the same won’t be negative unless the rate of return is set higher than the 81.90% which happens to be the IRR of the project. The r of the project being only 20%, there is very less chance of the project losing significant cash flows and thus there is enough bumper for the management to work the project out and making it a profitable project (BERK & DEMARZO, 2016). 

The other factors which the management of the company ( Jones brother Marbles company) shall considered is as follows:

  1. The primary factor (non-financial) which shall be considered b the management is that of increasing the product portfolio, reach new market without affecting the current sales of the company. 
  2. The increasing portfolio of the company would help in the increasing employee morale and provide a higher platform to showcase their talent and reach new markets. 
  3. The company’s management shall also consider the current legislations regarding production and future legislative changes before implementing the project. Any probable changes in the taxation rules must also be considered. 
  4. The management of the company shall also consider the availability of trained ad skilled manpower for undertaking the new project and the existing market for new products (Atrill, 2013).
  5. The capital structure of the company shall be examined to ensure the debts being considered is not going to increase leverage too much and increase the company’s financial risk. The debt-equity component shall be kept under check and expected limit all the time as any probable high leverage would-be expected to increase the discounting rate.   
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