Lifestyle Furniture - Fundamentals of Value Creation in Business - Case Study Example

Case Study – Lifestyle Furniture

Executive Summary

This paper provides an investment appraisal for Lifestyle Furniture to choose between the two options of renewing its existing machinery or replacing it with a new machine. The cash flows related to each decision have been converted to their Net Present Value (NPV) and compared. The Internal Rate of Return (IRR) and the Profitability Index (PI) have also been calculated. The decision is clearly in favor of the alternative of replacing the machine. A sensitivity analysis has also been carried out for three changes to the base case --- applying inflation to the costs of operation, reduction in projected sales and increase in operations and maintenance costs. The sensitivity analysis also supports a decision to replace the machine with a new one instead of renewing it.

Introduction

Lifestyle Furniture is one of the leading on-line retailers of solid hardwood furniture with a cumulative sales turnover of over $ 13 million and cumulative profits of over $ 1.75 million by the end of 2015. The company wishes to improve its production line. The company has the options to renew its existing machinery or to replace it with a new generation of machines. This report compares the two alternatives from the financial viewpoint and makes the recommendation on the alternative to be selected.

Investment appraisal is done by calculating the cash flows expected from each alternative and converting them to their present value. This process recognizes the time value of money where a dollar today is worth more than a dollar tomorrow. Since the cash flows are based on projected figures, a sensitivity analysis is also applied to see if the decision would change if assumptions change (Eakins, 2002). Additionally two other measures the Internal Rate of Return and the Profitability Index have also been calculated.

1(a) Cash Flow from Alternative 1 – Renewal of existing machine

The NPV calculation together with the IRR and PI calculations is shown in Appendix - 1. In this table, Year 0 is considered the year of making the investments and years 1 through 5, the period in which the investment results in operating cash flow. Sales revenues are shown as $ 800,000 in Year 1 and growing 13.5% per year in the next 4 years. Cost of materials is a constant 32% of sales. Other costs are assumed constant over the 5 years. The interest on the bank loan of $ 135,000 is included in the total expenses and the operating cash flow has been calculated.

The investment in Year 0 includes the machine renewal cost of $ 135,000 and the $ 15,000 increase in net working capital. In Year 5, the salvage value of the machine has been included as a cash inflow. The cost the feasibility study of $ 25,000 is not included as it is a sunk cost. A sunk cost is defined as a cost that cannot be recovered no matter what investment decision the company makes (Maranjian, 2013).

The Net Present Value (NPV) of the Cash Flows from Year 0 through Year 5 has been calculated using the Excel formula “=NPV (rate, cash flow Year 0: Year 5)”. The discounting rate is 17% which is the cost of capital for the company. The NPV works out to $ 359,330 which makes it an attractive project.

The Internal Rate of Return (IRR) is the discounting rate when the discounted value of future cash inflows matches the initial cash outflow, i.e. NPV equals 0. The IRR is 74.36% which is very attractive.

The Profitability Index (PI) is defined as (Net Present Value ÷ Initial investment) and the figure is 2.40.

1(b) Cash Flow from Alternative 2 – Replacing with a new machine

The NPV, IRR and PI calculations are shown in Appendix-2. The structure of the worksheet is exactly similar to the worksheet for Alternative 1, applying the figures for Alternative 2 from the case data. In the above calculation, the $ 20,000 that can be realized from selling the old machine has been excluded to make a fair comparison between the two alternatives. Including the realization from sale of the old machine in Year 0 would make the alternative 2 even more attractive than alternative 1.

The Net Present Value (NPV) for this alternative is $ 798,773. The Internal Rate of Return (IRR) is 103.37% and the Profitability Index (PI) is 3.07.

2. Recommendation based on the above calculations

The recommendation based on the above calculations is clearly for the company to choose Alternative 2 which is to replace the existing machine with a new machine.

• The NPV for replacement of the machine is $ 798,773 which is higher than the NPV for renewing the machine which is $ 359,330.
• The IRR for replacing the machine is 103.37% compared to 74.36% for renewing the machine
• The Profitability Index (PI) for replacing the machine is 3.07 compared to 2.40 for renewing the machine.

Adding the $ 20,000 realizable from the sale of the old machine would make Alternative 2 even more attractive than Alternative 1.

Between these two alternatives, there is no conflict between the various methods of investment appraisal. The alternative of replacing the machine is superior to renewing the machine in all three methods of appraisal.

It must be remembered that investment appraisals are based on projected numbers and if those projections are wrong, the conclusion reached would also be wrong (Averkamp, n.d.).

3. The NPV Profile of the two projects

In the above NPV graph, the graph for machine replacement is entirely above the graph for machine renewal since at all values for cost of capital, the NPV for machine replacement is higher than that for machine renewal. Conflicts could occur if the cash flows from one project occur early in the project and for the alternative project they occur later in the project. In such a case, the two graphs would be seen to cross. Conflicts could also occur if the NPV is higher for one project and the IRR is higher in the project (McGowan, 2013). In this specific case both the NPV and the IRR are higher for the machine replacement case and no conflict is observed.

4. Revised NPV with inflation applied on costs

The cash flow calculations for the two alternatives with inflation factors applied to the various costs are shown in Appendix-3.

For Alternative -1, with inflation rates applied to various elements of expenses as shown above, the NPV for this alternative falls to $ 278,114 from $ 359,330 without inflation. The IRR falls to 65.24% from 74.36% and the PI falls to 1.85 from 2.40.

For Alternative- 2, with inflation the NPV falls to $ 721,568 compared to $ 798,773 without inflation. The IRR falls to 98.24% compared to 103.37% and PI falls to 2.78 from 3.07.

The recommendation to choose Alternative 2 of replacing the machine does not change with applying inflation to the costs.

5(a) Extent of Sales revenue fall to make project unfeasible

The worksheets are shown in Appendix -4. For Alternative-1 of renewing the machine, if the Year 1 sales reduce below $ 646,410, the NPV would become negative and the project would become unfeasible.

For the Alternative 2 of replacing the machine, if the Year 1 sales fall below $ 658, 570, the NPV becomes negative and the project becomes unfeasible.

The recommendation in favor of Alternative 2 does not change as the sales projection would have to fall 34.1% from projection for the alternative to become unfeasible compared to only a 19.2% fall for Alternative 1.

5 (b) Extent of rise in operating and maintenance costs to make project unfeasible

The worksheets are shown in Appendix-4. For the base case for Alternative 1- renewal of the machine, the operating costs are $ 75.000 and the maintenance costs are $ 42,200 making a total of $117,200. If this goes up above ($ 206,400 + $ 42,200) = $ 248,600, the project becomes unfeasible since NPV becomes negative. This is a 112.1% increase from projections.

For the base case for Alternative 2- replacement of machine, the operating and maintenance costs total ($ 58,500 + $ 38,750) = $ 97,250. This would have to increase to ($ 350,610 + $ 38,750) = $ 389, 360 to make the project unfeasible. This is a 400% rise.

The recommendation in favor of Alternative 2 remains valid.

6. Comparison of Purchasing and Lease options for a machine

For buying the new generation of machinery, the company has various options: (Day, 2008)

• Buying the machine, either with its own money or with a bank loan. The machine becomes as asset of the company and it can claim depreciation each year for the lifetime of the machine. Depreciation acts as a cash inflow.
• Financial lease – where the machine is owned by the financial company and Lifestyle Furniture pays monthly or annual leasing charges. There is no large upfront cash outflow for the machine. Operation and maintenance costs are to be borne by Lifestyle Furniture. At the end of the lease period, the machine will be repossessed by the financial company. In some financial leases, the lessee company is given the option to buy the machine at a discounted value. The leasing costs can be treating as operating costs by Lifestyle Furniture which will lower operating profits and the taxes payable. Depreciation cannot be claimed as the asset is not owned by Lifestyle Furniture.
• Operating lease – where the machine is owned and maintained by the leasing company. Operating costs are borne by Lifestyle Furniture. Other conditions are similar to that of the financial lease arrangement.

In general, buying a machine would have lower effective costs than financial leasing. Operating leases would be even more expensive than financial leasing. Buying would require paying upfront either from the buyer’s own money or through a bank loan. Companies opt for financial or operating leases if they have a liquidity problem or are uncertain of the success of a project or if they expect a technology change which would bring better machines into the market in the near future. For Lifestyle Furniture, the investment in buying the new machine is only slightly larger than the Year 1 cash inflow from operations. Buying would be the more economic option than a financial or operating lease arrangement.

7. Weighted Average Cost of Capital for Lifestyle Furniture

The calculation of the Weighted Average Cost of Capital (WACC) is as below: (Wilkinson, 2013)

WACC = { E ÷ (E+PS+D)} x Ke + { PS ÷ (E+PS+D)} x Kps + { D ÷ (E+PS+D)} x (Kd – Tax rate)

Where E = Equity, PS = Preference Shares and D = Debt

Ke = Cost of Equity, Kps = Cost of Preference Shares and Kd = Cost of Debt

The calculation is shown in the tabulation below. Since interest on date is a pre-tax expense, the effective cost of capital has been taken as 70% of the nominal rate assuming that Lifestyle Furniture has a tax rate of 30%.

(in $)

Book Value

Market Value

Cost of capital

Effective Cost of Capital

Long term Debt

4,000,000

3,840,000

6%

4.2%

Preference Share Capital

40,000

60,000

13%

13%

Ordinary Equity

1,060,000

3,000,000

17%

17%

Total

5,100,000

6,900,000

Cost of Debt

3.29%

2.34%

Cost of Preference Capital

0.10%

0.11%

Cost of Equity

3.53%

7.39%

WACC

6.93%

9.84%

The WACC should be based on the weight of the market values of the components of capital since an investor and lender would expect a market rate of return rather than a return based on book values (Evans, 2015).

The recommendation based on the findings

The clear recommendation to Lifestyle Furniture to go ahead with Alternative 2, replace the existing machine with a new machine. They should go ahead with buying the machine financing it with a bank loan as the effective cost of the loan would be the post-tax rate of 4.2%. Financial or operating leases would cost them more. The decision is correct even if there is a shortfall in the projected sales revenues and if the costs of operation and maintenance are higher than estimated. The decision also stands if operating costs increase due to inflation.

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