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Homework answers / question archive / The management of Thermotech Industries Co
The management of Thermotech Industries Co. is considering a new investment project to introduce a new model of digital laser thermometers utilizing a new technology that will help reduce production costs significantly. Thermotech spent $5 million for the past two years to develop the technology. Given the current market conditions and technology levels, the new product will have marketability over the next ten years, after which the technology might become obsolete and the product would be replaced with newer and better ones. Based on this projection, the management assesses that the life of the investment is ten years.
It is projected that, once the investment is taken, it will require capital expenditures as much as $40 million for the machine setup. Straight-line depreciation will be used for the machines over the life of the investment (full depreciation over 10 years). While the machines will not be used after 10 years when the investment is over, Thermotech might still be able to sell them to a foreign buyer in the second hand market for as much as $5 million. The production also requires a production facility in which the machines will be placed. The management will use a warehouse which is currently empty but had been rented out until last year for $120,000 a year.
The following table shows the projected sales of the digital laser thermometer over the next ten years. The costs of goods sold and other expenses (depreciation not included) are projected to be around 50% of the sales.
<Table 1> Sales Projections (Unit: $1,000)
Year 1 2 3 4 5 6 7 8 9 10
Sales 8,000 10,000 20,000 22,000 24,000 24,000 22,000 20,000 10,000 6,000
The management of Thermotech sees that it is proper to maintain the level of net working capital (NWC) at about 30% of total expenses (depreciation not included) each year to prevent any interruptions in operation. It is assumed that the needed NWC amount is prepared at the beginning of each year. That is, the 30% of the total expenses in year t will be charged as the year’s NWC at the beginning of the year. Of course, any investments in NWC will be recovered fully at the end of the project. This means that at the termination of the project there will be no NWC left.
Thermotech has good capital standing with 100% equity in its capital structure. Thermotech common stock is listed in the stock market. According to the report given by the company’s financial advisor, Thermotech’s beta is estimated at 0.6 and the broad market index yields an expected return of 10%. The market interest rate is 2% a year.
Thermotech’s corporate tax rate is 30%. The new investment is expected to affect the cash flows from some of the products produced currently by the company. According to the marketing team, it is projected that the annual losses due to the reduction of the sales from the existing products might amount to as much as 5% of the after-tax cash flows from the new investment.
For capital budgeting, Thermotech’s management has traditionally used average account return and simply payback period as their investment assessment tools. They use a half of an investment’s life as the cutoff period for the payback period method.
Answer the following questions.
Q.1 Comment on Thermotech’s capital budgeting practices. Are they appropriate? What advice are you going to give to the management?
Q.1. Comment on Thermotech's Capital Budgeting Practices.
The capital budgeting decision is to whether to go for the new Investment in digital thermometers or not. This investment has an impact on two areas
1. Loss of revenue from the warehouse.
2. Loss of Revenue of existing Business.
The capital budgeting tools should be able to cater to these conditions and give the company appropriate guideline.Thermotech is currently using two Investment (or Capital budgeting) methods.
1. Payback period - Time during which the company will breakeven. The breakeven target is put as 5 years (half of investment life). While this measure gives the time in which returns will happen, in the current Thermotech scenario this will be just a data point for comparison against their target of 5 years.
2. Average Account Return - This method gives the average returns over the period of the life of the contract. The purpose of this project is again to compare whether the returns are in-line with company and market expectations. Also to compare agains the existing project options.
While the above two methods give a fair decision making capability to the Management, there is a key aspect which is missing here i.e. the time value of money. In projects which have significant upfron capital investments ($40M upfront investments for about $166M total Revenue), time value of money is very important since the payback method and Average account return could both give positive numbers but when the Net cash flows are discounted and if the Net Present Value (NPV) is not positive or grearter than the existing opportunities (of not investing in this project), then the Investment should not be done in this project.
So in conclusion the management should also look at NPV of the project/s in capital budgeting decision makings. Any good capital budgeting should be based on multiple measures to get a holistic view of the future business.
