Case Analysis:

For analyzing the main issues in this case, which included the decrease in profit margins from 2011, increase in the competition in steel and timber industry, obsolescence of production machines and the increased production cost. To overcome these main issues in  Magic Timber and Steel, some qualitative and quantitative analysis of two alternatives are performed below:

Qualitative Analysis:

The main issues were the increase in production cost, obsolescence of production machine, increase in competition and decrease in profit margins faced by Magic Timber and Steel in 2015. To overcome these issues, company considered the two alternatives:

First one was to repair the old production machine (Matrix), which had the main issue of obsolescence. This machine required heavy repair and maintenance cost at that time to upgrade the version along with the fixed$7,000 cost every year in repair and maintenance account. It would increase the cost of production along with the increased risk of labor damages because that machine was very sensitive for the production of timber and could kick back easily if labor did not put timber on its desired position. Also another problem with the old machine was that, it had the less capacity to produce goods. With this less efficient machine, Magic Timber and Steel had been very much concerned about its future ability to fulfill the demands of timber in the market.

The second was to replace the old machine (Matrix) with the new machine (Delta). To buy this new timber manufacturing machine, Magic Timber and Steel needed to take the loan on 6% annual interest payment upon principal amount with the repayment of principal amount after the completion of fifth year. The new timber manufacturing machine had the ability to increase the production capacity of Magic Timber and Steel with the advanced technology which enabled the machine to produce the cost efficient products which led to the low cost of production. If Magic Timber and Steel purchased this new machine, it would provide the competitive edge over its competitors by maximizing the profit and low production cost and low labor damage risks.

Quantitative Analysis:

The NPV sensitivity analysis regarding the purchase of new machine, provides the negative NPV when we considered the 11% discount rate and 30% tax rate:

Cash Flows: Year 0 Year 1  Year 2  Year 3  Year 4  Year 5
Immediate sale of Matrix 35,000        
Scrap forgone           (5,000)
Repair and Maintenance (Matrix) 28,000 7,000       7,000    11,000     7,000       7,000
Immediate Purchase of Delta (140,000)        
Repair and Maintenance (Delta) (2,000)     (3,000)    (4,000)    (5,000)     (6,000)
6% interest rate (8,400)     (8,400)    (8,400)    (8,400)     (8,400)
Savings in labor cost 5,250       5,500      5,750     6,000       6,250
Savings in electricity cost 4,725       4,800      4,875     4,950       5,025
Sales Proceeds of Delta           60,000
Net Savings and (Payments) of Tax (8,400) 428          630       (368)     1,035       4,238
Total Cash Flows (85,400) 7,003       6,530      8,858     5,585     63,113
Discount Factor 1 0.9009     0.8116    0.7312   0.6587     0.5935
Discounted Cash Flows (85,400) 6,309       5,300      6,477     3,679     37,454
Net Present Value (NPV) (26,182)

The – 26,182 NPV indicates that investment in new timber manufacturing machine (Delta) should not be done because it will consume the cash flows of the company but there is one thing to be considered and that is; this calculations only provides the information regarding the replacement of old machine (Matrix) into the new machine (Delta). These calculations do not contain the information regarding the increase in capacity of production and to meet the future expectations of market demand for timber.

In next step, we changed some criteria for carrying out the sensitivity analysis, for which we changed the interest rate from 11% to 10%, tax rate from 30% to 25%, sales proceed at the end of fifth year for Delta from 60,000 to 100,000, annual interest payment on principal amount from 6% to 5% and the Delta fixed maintenance rate at the first year of purchase from 2000 to 1000.

Cash Flows: Year 0 Year 1  Year 2  Year 3  Year 4  Year 5
Immediate sale of Matrix 35,000        
Scrap forgone         (5,000)
Repair and Maintenance (Matrix) 28,000 7,000 7,000 11,000     7,000 7,000
Immediate Purchase of Delta (140,000)        
Repair and Maintenance (Delta) (1,000) (2,000) (3,000) (4,000) (5,000)
5% interest rate (7,000)  (7,000)  (7,000)  (7,000)  (7,000)
Savings in labor cost 5,250 5,500 5,750     6,000 6,250
Savings in electricity cost 4,725 4,800 4,875     4,950 5,025
Sales Proceeds of Delta       100,000
Net Savings and (Payments) of Tax (7,000) (244)  (75)  (906)        263  (7,069)
Total Cash Flows (84,000) 8,731 8,225 10,719     7,213 94,206
Discount Factor 1 0.9091 0.8264 0.7513   0.6830 0.6209
Discounted Cash Flows (84,000) 7,938 6,798 8,053     4,926 58,495
Net Present Value (NPV) 2,209

The +2,209 NPV indicates that after performing the sensitivity analysis, we found an attractive view of the company with positive NPV………

 

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