PAYBACK, NET PRESENT VALUE, INTERNAL RATE OF RETURN, EFFECTS OF DIFFERENCES IN SALES ON PROJECT VIABILITY
Shaftel Ready Mix is a processor and supplier of concrete, aggregate, and rock products. The company operates in the intermountain western United States. Currently, Shaftel has 14 cement-processing plants and a labor force of more than 375 employees. With the exception of cement powder, all materials (e.g., aggregates and sand) are produced internally by the company. The demand for concrete and aggregates has been growing steadily nationally, and in the West, the growth rate has been above the national average. Because of this growth, Shaftel has more than tripled its gross revenues over the past 10 years.
Of the intermountain states, Arizona has been experiencing the most growth. Processing plants have been added over the past several years, and the company is considering the addition of yet another plant to be located in Scottsdale. A major advantage of another plant in Arizona is the ability to operate year round, a feature not found in states such as Utah and Wyoming.
In setting up the new plant, land would have to be purchased and a small build- ing constructed. Equipment and furniture would not need to be purchased; these items would be transferred from a plant that opened in Wyoming during the oil boom period and closed a few years after the end of that boom. However, the equip- ment needs some repair and modifications before it can be used. It has a book value of $200,000, and the furniture has a book value of $30,000. Neither has any outside market value. Other costs, such as the installation of a silo, well, electrical hookups, and so on, will be incurred. No salvage value is expected. The summary of the initial investment costs by category is as follows:
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Land
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$ 20,000
|
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Building
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135,000
|
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Equipment:
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|
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Book value
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200,000
|
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Modifications
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20,000
|
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Furniture (book value)
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30,000
|
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Silo
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20,000
|
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Well
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80,000
|
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Electrical hookups
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27,000
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General setup
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50,000
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Total
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$582,000
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Estimates concerning the operation of the Scottsdale plant follow:
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Life of plant and equipment
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10 years
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Expected annual sales (in cubic yards of cement)
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35,000
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Selling price (per cubic yard of cement)
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$45.00
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Variable costs (per cubic yard of cement):
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|
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Cement
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$12.94
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Sand/gravel
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6.42
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Fly ash
|
1.13
|
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Admixture
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1.53
|
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Driver labor
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3.24
|
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Mechanics
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1.43
|
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Plant operations (batching and cleanup)
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1.39
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Loader operator
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0.50
|
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Truck parts
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1.75
|
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Fuel
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1.48
|
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Other
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3.27
|
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Total variable costs
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$35.08
|
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Fixed costs (annual):
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|
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Salaries
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$135,000
|
|
Insurance
|
75,000
|
|
Telephone
|
5,000
|
|
Depreciation
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58,200*
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|
Utilities
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25,000
|
|
Total fixed costs
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$298,200
|
After reviewing these data, Karl Flemming, vice president of operations, argued against the proposed plant. Karl was concerned because the plant would earn signifi- cantly less than the normal 8.3 percent return on sales. All other plants in the com- pany were earning between 7.5 and 8.5 percent on sales. Karl also noted that it would take more than five years to recover the total initial outlay of $582,000. In the past, the company had always insisted that payback be no more than four years. The company's cost of capital is 10 percent. Assume that there are no income taxes.
Required:
1. Prepare a variable-costing income statement for the proposed plant. Compute the ratio of net income to sales. Is Karl correct that the return on sales is significantly lower than the company average?
2. Compute the payback period for the proposed plant. Is Karl right that the payback period is greater than four years? Explain. Suppose you were told that the equipment being transferred from Wyoming could be sold for its book value. Would this affect your answer?
3. Compute the NPV and the IRR for the proposed plant. Would your answer be affected if you were told that the furniture and equipment could be sold for their book values? If so, repeat the analysis with this effect considered.
4. Compute the cubic yards of cement that must be sold for the new plant to break even. Using this break-even volume, compute the NPV and the IRR. Would the investment be acceptable? If so, explain why an investment that promises to do nothing more than break even can be viewed as acceptable.
5. Compute the volume of cement that must be sold for the IRR to equal the firm's cost of capital. Using this volume, compute the firm's expected annual income. Explain this result.