The Wood Pellet Corporation The Wood Pellet Corporation (WPC) is considering opportunities to modernize (automate) its plant and equipment. Rachelle Brown, the president of the firm, is enthusiastic about an automation strategy and sees it as essential if the firm is to stay competitive. As a first step in the economic analysis of automated equipment, a cash-flow net present value calculation was done for one of the more desirable pieces of equipment. The firm conventionally uses 0.20 to evaluate investment opportunities (debt currently costs 0.131 before tax). The statutory corporate tax rate is 0.46. Exhibit 1 shows the capital budgeting analysis for the $10,000,000 investment. The entire amount of investment is eligible for a 0.10 investment tax credit. The tax basis of the investment is $9,500,000 ($10,000,000 minus half of the $1,000,000 investment tax credit). The estimated life of the equipment is five years with zero salvage value at the end of that period of time. The firm uses the accelerated cost recovery system method of equipment write-off for taxes shown in Table 18.1Links to an external site. The equipment will save $3,000,000 of labor costs per year. It will have a capacity of 2,500,000 units per year. These cost and capacity figures are based on solid information and can be relied on to be correct. Rachelle accepts the cash-flow assumptions that result in the $1,600,896 negative net present value, as shown in Table 18.1Links to an external site. But she is bothered by the long-run consequences of rejecting the investment. She knows that the firm must modernize if it is to stay competitive. Rachelle also thinks it essential that any investment enhance the financial position of the stockholders. The negative net present value is disconcerting. Table 18.1 Capital budget analysis, $10 million investment There are several other factors not directly incorporated into the cash-flow analysis. The investment will increase the quality of the output. The product will be more consistent in its characteristics and thus more attractive to the purchasers. The economic value of this characteristic was thought to be too difficult to measure and was not included (its inclusion would have decreased the reliability of the cash flow measures used). Moreover, the investment would increase the firm’s productive capacity by 50 percent. With this increased capacity, the firm could react more rapidly to new orders and deliver goods straight from production rather than from inventory. It is estimated that the average inventory carried during a year could be reduced by $10,000,000. The annual after-tax cost of carrying inventory is estimated to be 0.25 of the investment. A third advantage of the new equipment is that it is more reliable and has less down time than the present equipment. This would improve the ability to service customers as well as reduce inventories (this factor did affect the estimated $10,000,000 inventory cost reduction). The product line that the equipment would produce is currently earning $7,000,000 of cash flow per year. The equipment being considered is a departure from the equipment used in the past. While it is felt that the five-year life estimate is reasonable, it is also felt that a new generation of this type of equipment will be forthcoming after five years. It is estimated that, if the current investment is made, $15,000,000 of future cost savings per year are feasible with improved versions of the equipment. Question: What is your recommendation regarding the investment? Show calculations
The Wood Pellet Corporation The Wood Pellet Corporation (WPC) is considering opportunities to modernize (automate) its plant and equipment. Rachelle Brown, the president of the firm, is enthusiastic about an automation strategy and sees it as essential if the firm is to stay competitive. As a first step in the economic analysis of automated equipment, a cash-flow
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