Finance - Accounting
Read through the Sharon Pipe Case. Answer the following questions:
Q1) What is the decision facing Mr. Todd?
Q2) The accountant’s estimates in Exhibit 2 use the “most likely” sales projection in Exhibit 1 for each year. Is this appropriate?
Q3) Fill out the following information in the excel file.
Sharon Pipe, Inc.
Expected Output
Nominal discount rate
Tax rate
Expected Inflation
CurrentPuchase price per pound
Distribution Costs per pound
Purchase price
SV in 8 years
Straight-line depreciation years
Extra Credit - Construct the cash flows and calculate the NPV when there is no inflation. (Use excel template.)
Note - if you are more comfortable working on pen and paper, print out the excel sheet and submit the homework before class.
Sheet1
Sharon Pipe, Inc.
Exhibit 1
Annual Sales Probability
1,000 0.10 1300
1,200 0.60
1,600 0.30
Exhibit 2 Incremental?
1. Raw materials $384,000 $384,000.00 Yes
2. Distribution cost 24,000 24000 No
3. Direct labor 40,000 40,000 Yes
4. Indirect labor 8,000 8000 No
5. Pension and welfare 6,720 6720 Yes, only direct labor component
6. Payroll taxes 4,800 4800 Yes, only direct labor component
7. Utilities 8,000 8,000 $0.0067 Yes
8. Repairs and maintenance 7,000 7,000 Yes
9. Floor space 6,600 6,600 No, allocated costs
10. General factory 18,000 18,000 No, allocated costs
11. Depreciation 75,000 75000 Yes
12. Lost interest 78,000 78000 Yes
$660,120
Based on production of 1,200,000 pounds / year
1. Raw materials $0.32 per pound
2. Distribution cost $0.02 per pound
3. Direct labor $40,000 per year after the 3rd year
$40,000 per year during first 3 years w/ 20\% probability
4. Indirect labor 20\% of item 3
5. Pension and welfare 14\% of items 3 plus 4
6. Payroll taxes 10\% of items 3 plus 5
7. Utilities $0.0067 per pound
8. Repairs and maintenance $7,000 fixed
9. Floor space $6,600 fixed
10. General factory $18,000 fixed
11. Depreciation $75,000 based on cost of equipment depreciated 8 years
12. Lost interest $78,000 lost interest on the $600,000 used to purchase the equipment
Sheet2
Sharon Pipe, Inc.
Nominal discount rate
Tax rate
Expected Inflation
Current
Puchase price per pound
Distribution Costs per pound
New Equipment
Purchase price
SV in 8 years
Straight-line depreciation years
Sharon Pipe, Inc.
(No Inflation)
Expected Output
Years
0 1 2 3 4 5 6 7 8
Cost of not purchased pipe
Distribution Cost Savings
Raw Materials Cost
Distribution Cost
Direct Labor
Indirect Labor (supervisor)
Pension
Payroll Tax
Utilities
Maintenance
Depreciation
= D EBIT
= Δ EBIT (1-T)
Depreciation
Capital Expenditures
Salvage Value
Tc(SV-BV)
Increase in NWC
Δ Cash Flow
× PV Factor
= $PV
NPV @ 13\%
IRR
Payback period
SHARON PIPE, INC.
“If we do decide to produce the 10- and 12-inch pipe internally, it could solve our overstaffing problem,” Mr. Ronie Todd, owner of Sharon Pipe, Inc. (SPI), remarked to Mr. Bill Long, the plant manager. “I’m reluctant to lay off anyone or even cut back hours. It’s not good business and it’s not the right thing to do if it can be at all avoided.”
The vast majority of SPI’s sales come from drainage pipe, which is mainly used in various types of sewer systems. The pipe comes in a variety of sizes, and sales depend in part on customers perceiving the company as a “full-line producer.” That is, a sales person is more likely to win an account if a distributor knows that a producer can promptly deliver various sizes of pipe. Typically this means that a manufacturer can quickly meet orders for the most commonly used sizes of pipe. These include pipe with diameters of 3 inches, 6 inches, and 8 inches.
Occasionally, however, a distributor also needs 10-inch and 12-inch pipe. SPI has never produced these sizes internally because management believes that annual sales volume is too low to justify the start-up cost. If a distributor does request such pipe, SPI buys the pipe from a competitor who does manufacture the requested sizes. Mr. Todd has never carefully analyzed whether this is a good policy, and he thinks now is the time to do so, especially given the firm’s staffing situation.
As Mr. Todd thinks about it, there are two key benefits of producing the 10-inch and 12-inch pipe internally. First, SPI will avoid the cost of buying the pipe from a competitor. SPI pays 45 cents per pound for this pipe plus another 2 cents per pound in distribution costs to deliver the pipe to customers. Unit selling price is 56 cents per pound. Second, SPI’s staffing problems would be helped.
Though dollar sales have increased slightly in the last two years, Mr. Todd recognizes that the company is overstaffed by two employees. Sales simply aren’t sufficient to keep all the production employees working full time. Mr. Todd thinks this could continue, given the state of the economy.
In its 10-year history, SPI has never cut any worker’s hours and has never laid off any employee. Mr. Todd is firmly committed to not doing so now.
Mr. Todd can’t be certain, of course, what sales of the 10-inch and 12-inch pipe will be in the future. He finds it helpful to think in terms of possible outcomes. He has set forth estimates along these lines in Exhibit 1.
In addition, some sales people have complained that accounts have been lost when distributors realize that SPI does not produce 10-inch and 12-inch pipe internally. These distributors are worried that SPI will not be able to fill orders quickly. As a result, these sales people argue, the entire account, including 3-inch, 6-inch and 8-inch pipe, has been lost, not just the orders for 10-inch and 12-inch pipe.
Mr. Todd is not sure how to evaluate this “lost order” argument. For the time being, he has decided to ignore that question. He needs time to investigate the claims of the sales personnel who, he believes, have a strong incentive to inflate lost sales opportunities.
The equipment that is required to produce the 10-inch and 12-inch pipe costs $600,000 and can generate 2 million pounds of pipe per year. To analyze the opportunity, Mr. Todd will use straight-line depreciation to zero book value over the eight-year life of the project. Estimating the market value of the equipment after eight years is problematic. Mr. Todd expects that it will be worth $180,000 after taxes, though he recognizes that the market value could be as low as $120,000 at that time. Mr. Todd has also determined that the investment in net working capital will be the same regardless of whether SPI makes or buys the 10-inch and 12-inch pipe.
SPI’s accountant, Mr. Rory Congrove, has completed an analysis that he believes “strongly indicates” that in-house production is a “losing proposition.” (See Exhibit 2.) Mr. Congrove estimates it will cost 55 cents per pound to produce the 10-inch and 12-inch pipe while SPI can buy the same pipe for 45 cents per pound from another manufacturer and incur another 2 cents per pound to deliver the pipe to customers. As a result, Mr. Congrove argues that internal production will mean an 8 cent per pound loss, or $96,000 per year assuming 1.2 million pounds of pipe are produced.
In conducting his analysis, Mr. Congrove has used Mr. Todd’s estimates and annual sales probabilities. Mr. Todd wonders, though, how accurate the accountant’s numbers really are. For one thing, the estimates are based on the “most likely” sales figure and do not consider the other sales possibilities. In addition, Mr. Todd questions the appropriateness of including depreciation, given that it is a non-cash item. For these and other reasons, he decides to reconsider the analysis.
Mr. Todd is comfortable with many of the items listed in Exhibit 2. In his view, it is quite reasonable to project raw material cost of 32 cents per pound. And, the project will use two laborers and will require plant space and supervisory personnel. However, the company has significant excess space and the equipment will be operated in an area of the factory that will otherwise be vacant for the foreseeable future. In addition, Mr. Todd believes that the firm’s plant manager can easily supervise the project without affecting her efficiency in other areas.
Mr. Todd then thinks further about SPI’s staffing situation. Although it may not be good business, he is at ease with his decision not to terminate any employees. He realizes that at most, SPI will be over-staffed for three years, since two workers plan to retire at that time. And there is the possibility that sales will increase sufficiently during the next three years so that all the staff will be fully utilized over that three-year period. If this does occur, of course, new workers would have to be hired (but no new supervisors) if the 10-inch and 12-inch pipes are produced internally. Mr. Todd estimates there is a 20 percent chance that this will happen in any given year. Considered from a different angle, there is an 80 percent chance in each of the next three years that the two laborers used in the project will not be productively employed elsewhere in the business.
SPI’s nominal cost of capital is 13\% for all projects. SPI has a marginal tax rate of 40\%.
ASSIGNMENT
(Note: This case is a classic example of the “make v. buy” decision that many companies confront. Is it better to make a product in-house or to buy the product from another producer?)
1. The accountant’s estimates in Exhibit 2 use the “most likely” sales projection in Exhibit 1 for each year. Is this appropriate?
2. Should the project be undertaken? (Don’t forget the after-tax salvage value of the equipment.)
3. Recall that Mr. Todd is unclear what the market value of the equipment will be after eight years. He thinks it could be as low as $120,000 after taxes. How should this be taken into account in your analysis?
4. Mr. Todd is concerned because the accountant may have ignored inflation in his analysis. While the first year costs are correct, Mr. Todd believes the accountant has simply forgotten about the effects of inflation on the project cash flows after the first year. Mr. Todd’s expectation is that total labor costs including benefits will increase annually at the rate of inflation of 3 percent per year, starting in the fourth year of the project (with no inflation effect in years 1-3).
Mr. Todd expects that raw material costs will increase with inflation (at 3\%) in every year of the project. He also expects the unit cost of purchased pipe (at 45 cents in the first year) to increase annually at the rate of inflation during the life of the project. And inflation will not affect any other items.
Now what do you recommend?
5. How would you take into account the “lost sales” argument made by the sales personnel?
6. How would you take into account the “lost interest” on the investment?
7. The payback period for Mr. Todd is also interested in the payback period and internal rate of return for this project. What are they?
8. Suppose the equipment has a useful life of eight (8) years, but the project will continue past that date with another new machine. How would that affect the analysis?
EXHIBIT 1
Mr. Todd’s Estimate of the Probability Distribution of Annual Sales of 10-inch
and 12-inch Pipe, Years 1 - 8 (in thousands of pounds).*
Annual Sales
Probability
1,000 lbs.
.10
1,200
.60
1,600
.30
*These estimates do not consider the possibility that in-house production may increase sales (see case.)
EXHIBIT 2
Accountant’s Estimate of Annual Cost of Producing
10 inch and 12 inch Pipe In-House
1.
Raw materials
$384,000
2.
Distribution cost
24,000
3.
Direct labor
40,000
4.
Indirect labor
8,000
5.
Pension and welfare
6,720
6.
Payroll taxes
4,800
7.
Utilities
8,000
8.
Repairs and maintenance
7,000
9.
Floor space
6,600
10.
General factory
18,000
11.
Depreciation
75,000
12.
Lost interest
78,000
$660,120
Description of the above items:
1. 32 cents per pound times 1.2 million pounds per year.
2. 2 cents per pound times 1.2 million pounds per year.
3. Two workers at $20,000 per year each.
4. 20 percent of item 3. This is the project’s allocated share of supervisory salaries.
5. 14 percent of items 3 plus 4. This includes the firm’s contribution to the employee’s pension fund.
6. 10 percent of items 3 plus 4. This item encompasses social security tax and unemployment insurance both based on employee expense.
7. The project’s marginal (i.e., incremental) cost of electricity, heat, water, and so forth are based on production of 1.2 million pounds per year.
8. Maintenance and repair of the equipment regardless of the level of production.
9. The project’s allocated share of the factory space occupied by the equipment and the two workers.
10. The project’s allocated share of property taxes, corporate fees, secretarial support, and so forth.
11. Based on the cost of the equipment: $600,000/8 = $75,000/yr.
12. Lost interest on the $600,000 used to purchase the equipment: .13 ( $600,000 where .13 is the project’s after-tax discount rate.
Unit cost = $660,120/1,200,000 units = 55.0 cents
5
MGMT 413, Fall 2021
Sharon Pipe, Inc. - 1
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