Business Decision Making at Lambert Heating - Case Study Example

The Management of Lambert A.N. Financial Consultant Planning and Control of Expenditure May 24, Report Introduction Capital expenditure decisions are one of the most important decisions that firms make. It usually involves a large outlay of funds and so care must be taken to ensure that the most profitable alternative is chosen. In order to facilitate this process, several criteria are used in making this decision. These criteria relate to different capital budgeting/investment evaluation techniques. Included among them are: i. The net present value (NPV); ii. The internal rate of return (IRR); iii. The profitability index (PI); and iv. The payback period Lambert currently has a choice of investing in either of three machines – Alumier which is a replacement for the current machine, Big EZ – which is supplied by an American firm, and Cial which is manufactured in Japan. The objective of performing an evaluation is to determine which of these three investment options will provide the best return to the shareholders of the firm. The Net Present Value (NPV) According to Ryan and Ryan (2002) the NPV is one of the most preferred investment appraisal techniques. This method strongly rivals the IRR as one of the most popular investment appraisal techniques. In fact, Campbell and Brown (2003) indicates that it performs better than IRR in relation to making choices between mutually exclusive projects but needs to be modified in capital rationing decisions and when project choices have unequal lives. Additionally, where projects are not divisible under capital rationing it may be best to invest in several small projects which exhaust the budget but have lower profitability ratios and generates a higher NPV when added together rather than a large project with a higher profitability which does not exhaust the budget (Campbell and Brown 2003). The main focus of the NPV approach is how the value of cash flows is affected by the time in which they are received or paid out. Therefore, tools relating to the time value of money are used to facilitate the comparability of cash flows that takes place in different time periods (Titman et al 2011). Cash flows are discounted at the cost of capital which is 10% in this case. The formula for calculating NPV is as follows: NPV = CF0 + ((CF1/(1 + IRR)1) + ((CF2/(1 + IRR)2) … ((CFn/(1 + IRR)n) The decision rule criteria indicate that projects with a positive NPV should be accepted. In the case of mutually exclusive projects, the project with the highest NPV value should be selected. Information on the NPV for the three investment options are shown in Table 1 in Appendix 1. The information in Table 1 indicates that the Alumier Machine and the Cial Machine will both yield a positive NPV. However, only one machine is required and so the two investments are mutually exclusive. Therefore, the machine with the highest NPV value should be chosen. The Alumier Machine will yield an NPV of ?32,180 compared to ?65,650 for the Cial Machine. The Internal Rate of Return (IRR) The IRR is another very popular and well recognized investment evaluation technique which along with NPV is rated above the other techniques (Titman et al 2011). It is the discount rate that yields an NPV of zero (Titman et al 2011). The IRR decision rule criterion is to invest in the project if the IRR is greater than the discount rate used in calculating the NPV. One of the most common problem that has been raised about the IRR is the possibility of multiple internal rates which conflict with each other or the possibility of none at all (Hazen 2003). The formula for calculating IRR which is similar to that used in calculating NPV and is given as: NPV = CF0 + ((CF1/(1 + IRR)1) + ((CF2/(1 + IRR)2) … ((CFn/(1 + IRR)n) = 0 This formula is used to find the rate of return where NPV = 0. The information relating to IRR for the three investment options are shown in Table 2 in Appendix 1. The information in Table 2 indicates that the IRR for the Alumier and the Cial Machines are higher than the recommended discount rate of 10%. That is, 11.86% and 14.96% respectively while that for the Big EZ Machine is lower at 8.23%. Since the investments are mutually exclusive the one that yields the highest IRR – the Cial Machine should be selected. The Profitability Index (PI) The PI is another very useful method of investment appraisal. It takes the present value of the cash flows in future years and divides it by the initial cash outlay. The formula for calculating the PI is: PI = ((CF1/(1 + IRR)1) + ((CF2/(1 + IRR)2) … ((CFn/(1 + IRR)n) ? Initial Capital Outlay The decision criterion for the PI is to accept the investment if the PI is greater than 1 – that is, the discounted present value of the future cash flows are greater than the cost of the investment. The information on the PI for the three investment options are provided in Table 3. The information in Table 3 indicates that the Alumier and the Cial Machines are good investments with PI of 1.064 and 1.13 respectively. However, since the projects are mutually exclusive and Cial has a higher PI, the Cial Machine should be purchased. This method is useful when ranking projects; however, it is not as popular as NPV and does not add much information (Titman et al 2013). The Payback Period The simple payback period is a very popular method but is normally used as a preliminary tool in conjunction with other techniques such as NPV and IRR in investment appraisal. It provides information on the number of years in which a project can payback the initial capital investment. The longer the payback period the more risky the project and so a shorter payback period is preferable. The decision criterion for this method is to carry out the investment if the payback period is less than the maximum number of years specified. However, no maximum period is specified in this scenario. Table 4 provides information on the payback period for the three alternatives. The information in Table 4 highlights the year in which the payback occurs and indicates that Big EZ Machine has a lower payback period of 3 years. This would indicate that this may be the least risky option. However, this method does not take the time value of money into consideration. If that is taken into consideration then the NPV calculation in Table 1 shows that the initial investment would not be repaid until after year 6 while the other two options would have repaid the initial investment by then. This method does not take into consideration the time value for money. However, this shortcoming can be addressed and would give the same adjusted cash flow as the NPV in Table 1 which suggests that the payback period is 6 years for Alumier and 5 years for Cial. The Big EZ Machine would not be paid back in the timeframe of 6 years given for the cash flows. Conclusion The calculations in Table 1 to 3 indicate that the Cial Machine is the best option for the company. This machine should be purchased since it not only has the highest NPV but the highest IRR and the highest PI. Additionally, when the simple payback method is adjusted for the time value of money the Cial Option has the shortest payback period of 5 years compared to its closest rival Alumier with a six year payback period. This is an indication that it is the best option. However, it is more risky than the Big EZ option which would allow the initial investment to be recouped in three years which is one year earlier. Risk is an important element in finance and the sooner initial investments are recovered the better it is for the company. The time value of money is also an equally important element and so these and other factors should be weighed when it is considered necessary. To: The Management of Lambert Heating From: Project Consultant Subject: Scheduling the Installation of the New Machinery Date: May 24, 2013 Report Introduction Businesses carry out projects in order to ensure growth and continued profitability. The installation of new machinery will take some time and is a project by itself. Project management techniques are normally used to schedule projects in order to ensure that they are properly controlled and managed. Project Management Techniques Project Management tools are used to schedule and control activities in a project in order to ensure that it is completed within a particular timeframe and that it is within budget and conform to the required specification (Wysocki 2009). The aim of this project is to install the new machinery in an efficient and effective manner. Several tools are required including a Gantt chart and a network diagram in order to facilitate the process. A Gantt chart is used to schedule the activities. It shows the activities to be completed as well as the start and completion dates of each activity. This is shown as horizontal bars which are shaded gray in Appendix 2. The activities are labelled from A to K. A network diagram is commonly used to control large and complex projects. There are different types of network diagrams – activity-on-node (AON) and activity-on-arrow (AOA). The one utilised in this case is the AOA. It shows which activities are required to be completed before others can start. The number in the leftmost box at the top of the node represents the earliest start (ES) date while the number in the box below represents the latest start (LS) date. The number in the rightmost box at the top of the node represents the earliest finish (EF) date while the number in the box below represents the latest finish (LF) date. ES and EF was arrived at through the process of forward pass while LS and LF are arrived at through the process of backward pass. In this case the start date for activities A, B and C is on the first day and that becomes their ES date to which the normal durations are added to arrive at their EF date. This is known as a forward pass. A backward pass in this case starts with the end date of the project which is the end of the 24th. This date is designated LF date from which the normal duration s deducted to arrive at LS date. If the next activity going backward is followed by two activities then the LS for that activity is the latest of the two activities which follows. For example in the case of Activity A which is followed by Activities D and E, Activity A’s LF date becomes Activity E’s LS date which is later than the LS for Activity D. The longest path through the network diagram is described as the critical path (Heizer and Render 2006). The information in Appendix 2 indicates that the machine will take a normal duration of 24 weeks to install. The project will start on Monday June 3 and is expected to be completed on Friday 15th November 2013. The activities that form the critical path of the project are Activities – B, F, I and K (See the Network Diagram 1 in Appendix 2 for the critical path which is highlighted in bold lines). It is the path with zero (0) slack. The calculation of the slack period is shown in the table below. Identifying Slack Period and Critical Path Activity Normal Duration Earliest Start (ES) Earliest Finish (EF) Latest Start (LS) Latest Finish (LF) Slack (LS - ES) On Critical Path? A 2 0 2 6 8 6 No B 3 0 3 0 3 0 Yes C 10 0 3 7 10 7 No D 7 2 12 5 15 3 No E 15 2 9 8 15 6 No F 9 3 18 3 18 0 Yes G 7 3 12 10 19 7 No H 4 12 19 15 22 3 No I 5 18 22 18 22 0 Yes J 3 12 17 19 24 7 No K 2 22 24 22 24 0 Yes The table shows the activities, their normal durations, earliest and latest start time, earliest and latest finish, and the slack period. It also indicates whether or not the activity is on the critical path. The slack is calculated by subtracting ES from LS. Another method is to subtract EF from LF. Therefore, when ES is different from LS a slack exists and when they are the same there is no slack. In the table above the tasks which are highlighted in blue are on the critical path and have zero slack. This means that in order for them to take less time more labour would be required. This method of speeding up the project to have it completed in less than normal time period is known as crashing. The minimum duration or crash time is shown in Appendix 2. It shows that if the project is speeded up by a maximum of three weeks at a cost of ?200 per day then the cost of crashing Activities F and I would be ?3,000 as shown in Appendix 2. Network Diagram 2 in Appendix 2 shows the critical path remains at B, F, I, K as before and that the total duration of the project has been reduced to 21 weeks. Therefore, project will be completed during the week ending 25th October 2013 after the adjustment has been made. Conclusion After completing the schedule and network diagram the project manager should determine the skills required for the different activities. The persons assigned should possess the necessary skills and be briefed on the requirements and reporting relationships. The project should be properly monitored and progress reports should be prepared on its progress on a regular basis. It should be noted that proper planning and control and communicating with team members are necessary in order for the program to be successful. To: The Management of Lambert Heating From: Operations Consultant Subject: Minimising the Cost of Procurement Date: May 24, 2013-05-23 Report Introduction Linear programming is a very powerful technique which is used by various firms to analyse complex activities. Some of the activities linear program can be used to solve include profit maximization problems, Product mix problems and Cost minimisation problems. It is also used in transportation planning and other complicated problems relating to decisions that the firm is required to make. In this case linear programming is being used to determine the minimum cost which the firm will incur in meeting its requirements for different quantities of five (5) different types of boiler. These boilers are supplied by three (3) different suppliers at different prices and this makes the task of determining the constraints very tedious. The problem is a minimisation problem and the objective function is stated as follows: Minimise Cost: 300X1 +480X3 + 725X2 Subject to the following constraints: Constraint 1: X1 ? 1,800 Constraint 2: X2 ? 800 Constraint 3: X3 ? 1,000 The problem can be solved both graphically and with the use of equations. However, in this case Microsoft Excel was used to set up the function and objectives in order to obtain the results. Where, X1, X2 and X3 are the quantities of Uno, Duo, and Tre. These are the boilers for which constraints that are specific to a particular supplier exist. The Linear programming set up is shown in Appendix 3. The leftmost column shows the three suppliers which are constrained in their ability to satisfy the firm’s requirements for the three boilers mentioned. These suppliers also supply other boilers as shown in Appendix 3. However, Centrale, Brunswich and Apex sell Uno, Duo and Tre boilers respectively, lower than the market. In the linear programming set up the other supplies were added to the constraint to obtain each of the three suppliers to obtain the combined total of the goods they supply. The answer report indicates that cost would be minimised at a cost of ?1,172 for the three products. This is shown in the answer sheet in Appendix 3. The shaded grey area has the results in terms of the amount of Uno, Duo and Tre required in the process of cost minimisation. Conclusion Linear programming is a useful resource in the development of various professionals. It requires guidance, especially in a challenging situation as this one. However, the important thing is to ensure that the objective function is properly defined and the constraints properly identified. Appendix 1 Investment Appraisal Techniques Calculation of Net Present Value (NPV)   NPV factor (10%) Alumier Machine   Big EZ Machine   Cial Machine Year Cash Flow/(Outflow) Adjusted Cash Flow Cash Flow/(Outflow) Adjusted Cash Flow Cash Flow/(Outflow) Adjusted Cash Flow 0 1 (500,000) (500,000) (500,000) (500,000) (500,000) (500,000) 1 0.909 50,000 45,450 200,000 181,800 150,000 136,350 2 0.826 100,000 82,600 150,000 123,900 150,000 123,900 3 0.751 150,000 112,650 150,000 112,650 150,000 112,650 4 0.683 150,000 102,450 50,000 34,150 150,000 102,450 5 0.621 150,000 93,150 25,000 15,525 100,000 62,100 6 0.564 170,000 95,880 25,000 14,100 50,000 28,200  NPV 32,180 (17,875) 65,650                 Table 1 - NPV Calculations for the Three Options Calculation of Internal Rate of Return (IRR) Year Alumier Machine   Big EZ Machine   Cial Machine Cash Inflow/(Outflow)   Cash Inflow/(Outflow)   Cash Inflow/(Outflow) 0 (500,000) (500,000) (500,000) 1 50,000 200,000 150,000 2 100,000 150,000 150,000 3 150,000 150,000 150,000 4 150,000 50,000 150,000 5 150,000 25,000 100,000 6 170,000 25,000 50,000 IRR 11.86%   8.23%   14.96% Table 2 – IRR Calculations for the Three Options Table 3 – PI Calculations for the Three Investment Options Calculation of Payback Period   Year Alumier Machine Big EZ Machine Cial Machine Cash Inflow/(Outflow) Cumulative Cash Inflow/(Outflow) Cumulative Cash Inflow/(Outflow) Cumulative 0 (500,000) (500,000) (500,000) (500,000) (500,000) (500,000) 1 50,000 (450,000) 200,000 (300,000) 150,000 (350,000) 2 100,000 (350,000) 150,000 (150,000) 150,000 (200,000) 3 150,000 (200,000) 150,000 0 150,000 (50,000) 4 150,000 (50,000) 50,000   150,000 100,000 5 150,000 100,000 25,000   100,000   6 170,000   25,000   50,000   Payback period   5 years   3 years   4 years Table 4 – Payback Period for the Three Investment Alternatives Appendix 2 Project Management Techniques ID Description of Activity Time (Weeks) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 A Order New machinery B Plan new physical layout of factory C Determine changes needed on existing machinery D Receive new equipment E Hire new employee to supervise the operation of the new machinery F Make changes needed to accommodate new machinery G Make changes needed in existing machinery H Train existing employees to use new machinery I Install new machinery J Disassemble old machinery K Conduct employee safety training on new installation Gantt chart – Installation of New Machinery Network Diagram 1 (Green line indicates critical path) Network Diagram 2 – showing changes (in blue) after crashing Activities F and I (Green line indicates critical path) Calculation of Crash Cost Task Normal Duration (weeks Minimum Duration (weeks) Maximum Reduction (weeks) Crash Cost per day (?) Crash Cost for Activities Crashed (Maximum Reduction in days x crash cost per day x number of days) A 2 2 - 200 B 3 3 - 200 C 3 3 - 200 D 10 8 2 200 E 7 6 1 200 F 15 13 2 200 2 x ?200 x 10 = ?2,000 G 9 7 2 200 H 7 6 1 200 I 4 3 1 200 1 x ?200 x 5 = ?1,000 J 5 4 1 200 K 2 2 1 200 Total ?3,000 Appendix 3 Linear Programming Excel Set Up of Linear Programming Problem Supplier Uno Duo Tre     Constraints Result 1.47619 0 1.547619   Apex 2000 1500 1000 4500 >= 4500 Brunswich 0 800 3000 4642.857 >= 3800 Centrale 1800 1500 3000 7300 >= 7300 Cost 480 725 300 1172.857     Microsoft Excel 11.0 Answer Report Worksheet: [Book1]Sheet1 Report Created: 5/24/2013 3:34:48 AM Target Cell (Min) Cell Name Original Value Final Value $E$6   0 1172.857143 Adjustable Cells Cell Name Original Value Final Value $B$2 Uno 0 1.476190476 $C$2 Duo 0 0 $D$2 Tre 0 1.547619048 Constraints Cell Name Cell Value Formula Status Slack $E$3 Apex 4500 $E$3>=$G$3 Binding 0 $E$4 Brunswich 4642.857143 $E$4>=$G$4 Not Binding 842.8571429 $E$5 Centrale 7300 $E$5>=$G$5 Binding 0 Microsoft Excel 11.0 Sensitivity Report Worksheet: [Book1]Sheet1 Report Created: 5/24/2013 3:34:48 AM Adjustable Cells     Final Reduced Objective Allowable Allowable Cell Name Value Cost Coefficient Increase Decrease $B$2 Uno 1.476190476 0 480 120 300 $C$2 Duo 0 360.7142857 725 1E+30 360.7142857 $D$2 Tre 1.547619048 0 300 500 60 Constraints     Final Shadow Constraint Allowable Allowable Cell Name Value Price R.H. Side Increase Decrease $E$3 Apex 4500 0.214285714 4500 655.5555556 2066.666667 $E$4 Brunswich 4642.857143 0 3800 842.8571429 1E+30 $E$5 Centrale 7300 0.028571429 7300 6200 590 References Campbell, and James, (2003). Benefit-Cost Analysis: Financial and Economic Appraisal Using Spreadsheets. Cambridge, UK: Cambridge University Press Hazen, G. B (2003). A new perspective on multiple internal rates of return. The Engineering Economist, 48(1), p. 31 - 51 Heizer, J and Render, B. (2006). Operations Management. 8th ed. New Jersey: Pearson/Prentice Hall Ryan, P and Ryan, G. (2002). Capital Budgeting Practices of the Fortune 1000: How Have Things Changed? Journal of Business and Management, 8(4), p. 282 - 286 Titman, S., Martin, J.D and Keown, A.J. (2011). Financial Management: Principles and Applications. Prentice Hall Wysocki, R.K. (2009). Effective Project Management: Traditional, Agile, Extreme. 5th ed. USA: John Wiley & Sons, Inc Read More