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Bedano, Jeremy Investment Economics Prof.

Wilfred Manuela
Cruz, Leonard June 23, 2017 WAC #3
Lacar, Sean
Macawile, Mark
Learning Team 2

Magic Timber and Steel: Written Case Analysis

Magic Timber and Steel, a timber company formed in 1999, has recently been
experiencing decreasing revenues and turnover. This was attributed to many factors which
include, infrastructure issues and a slowdown of tourism. During early 2015, Magics owner,
John Davidson, believes that an investment in equipment is necessary to reinvigorate the
business. He currently has a dilemma whether buying a new machine is worth the investment or
it is better to keep and sustain the old machine instead.

The method used to arrive at a decision was the Net Present Value (NPV) method. This
method suggests that projects with a higher NPV should be taken over lower NPV projects. To
arrive at the project NPV, three items need to be determined: Operating Cash Flow, Change in
Net Working Capital, and Capital Spending. The items below show how each item was
computed.

Operating Cash Flow (OCF)

Operating Cash Flow describes the flow of cash over a projects lifetime. Put simply, it is
the net of revenues after cash expenses and taxes. However, in the case revenue and profit
forecasts were made only for the existing machine. This same forecast might not be applicable
for the new machine. This is why a conservative assumption was made: the new machine does
not have any contribution on revenue. Hence, only cash expenses and taxes were made as the
decision factors for NPV since they differ between the existing and new machine. In addition,
since no tax rate was described in the case, the group considered two scenarios: zero tax rate
and a 30% tax rate.

Scenario 1: Zero Tax Rate

In this scenario, a 0% tax rate was assumed. For the case of the existing machine,
operating cash flow was based on the following:
OCF = E BIT Depreciation
Since revenues were not considered in the NPV decision, as explained earlier, only the
relevant costs were considered. These were the following: Labour, Electricity, and Machine
Maintenance Costs. As stated in the case, a constant depreciation cost was also attributed to
the existing machine. Exhibit 1 shows the operating cash flow for a zero-tax scenario with the
existing machine.
For the case of the new machine, costs on labour, electricity, and machine maintenance
were also used as the basis for the OCF. The savings brought about by the new machine were
also deducted from these costs. Savings in labor costs include a 10% cost reduction that
increases by a fixed amount of $250 per year. On the other hand, savings in electricity costs
include a 10% reduction as well that increased by a fixed amount of $75 per year. Exhibit 2
shows the operating cash flow for the new machine.

Scenario 2: 30% Tax Rate

In this scenario, a 30% tax rate was assumed. This tax rate was assumed based on
typical corporate tax rates. For the existing machine, tax was computed and deducted from the
EBIT values obtained in Scenario 1. When tax is present, depreciation has a tax shielding effect
since it is deducted from the companys earnings. Exhibit 3 shows the operating cash flow for a
30% tax rate on the existing machine.

Likewise, for the new machine, the 30% tax rate was applied by also deducting
depreciation from the companys earnings. Like in Scenario 1, the savings brought about by
increased efficiency was also taken into consideration. Exhibit 4 describes the operating cash
flow for the new machine at a 30% tax rate.

Project change in Net Working Capital (NWC) and Capital Spending

The group identified the capital spending needed and the net working capital
requirements for both projects which, together with the operating cash flow, will be used to
evaluate their value.

Existing Machine
As per case facts, the firm must spend an upfront value of $28,000 to keep the existing
machine but there is no net working capital provided so the team left it blank. The $28,000
served as the initial investment even though it was really acquired years back. (See Exhibit 2).
Salvage value for the existing machine after 5 years is considered as a positive cash flow for the
capital spending.

New Machine
For this project, the group takes into account for the long term the capital invested in it.
The firm invested $140,000 at year 0. The investment will have a life of five years with book
value at $60,000 at the end of five years. There is also no net working capital provided, to
lessen the assumption, the team left it blank (See Exhibit 2). As the same case as in the existing
machine, it is also considered that the salvage value of the new machine is a positive cash flow
for the fifth year of the project in its capital spending.
Project Cash Flow and Value

Project cash flow is defined as the difference of the project operating cash flow and
project capital spending and change in net working capital.
P CF = OCF Change in N W C Capital Spending
The value computed for all the scenarios as described above lead the team to evaluate
the projected cash flow of each project. When taxes are considered, the Net Present Value for
the Existing Machine is -$718,433.71 while for the New Machine it is -$672,834.23. While when
taxes are not considered the Existing Machine is at -$1,028,256.21 while the New Machine is
-$956,157.23.

Recommendation

In the scenario where we opt to buy the new machine, we did not include the salvage
value of the existing machine in the cash flow. When doing an investing decision, we should not
consider the ways we finance a project - in this case if we take the salvage value and add it to
the cash flow. It is like saying that we finance the new machine with the value we got from the
sale of the existing machine.

We did the the projected cash flow without considering profits because, first, we do not
have data on the profits for the new machine, and, although we did a forecast of the profit (see
Exhibit 5), the model we got is based on the data from the existing machine and will not be
applicable to the new machine. To create a sound comparison, we opted to compare the two
using costs alone.

As we compare the Net Present Value (NPV) of both investments, be it with or without
tax, the NPV cost of the New Machine is always lower. When tax is not considered, the New
Machine costs $72,098.98 less than the Existing Machine. While, if tax is considered, the New
Machine costs $45,599.48 less than the Existing Machine.

Therefore, we recommend Magic Timber and Steel to purchase the new machine and
sell the existing machine.
Appendix:

Exhibit 1 : Existing Machine Projected Cash Flow Without Tax

Exhibit 2 : New Machine Projected Cash Flow Without Tax


Exhibit 3 : Existing Machine Projected Cash Flow With Tax

Exhibit 4 : New Machine Projected Cash Flow With Tax

Exhibit 5 : Forecasted Profits Using Linear Modelling

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