“ill cases FRANKLIN LUMBER CAPITAL BUDGETING PROCEDURES Pete Parker, the owner and CEO of Franklin Lumber is being quite frank with ‘Couriney Jones, a recent hire. “As told you at our interview, Im hiring you de- spite your MBA. I haven't had good experiences with MBA‘s. They tend to be e too technical, ack communication skils, and view problems as mere academic ‘exercises. But you seem to be different Your recommendations cited your sen- sitivity to real-world complexities and I've been impressed with your commu- nication and people skill. [think you can help us.” Jones received her MBA four weeks ago from a southern university with a regional and abit ofa national reputation. She received a numberof "big city” job offers but turned them down to accept a position with Franklin Lumber, a frm based in Lenoir, North Carolina. The company has four plants in the southeast, and primarily manufactures lumber that is used to produce var- ‘us types of furniture such as desks and doors. Jones took the job because she wanted a position with a small firm where she “could make a difference,” the company is located very near her family, andthe compensation is suprisingly attractive. She is also impressed with Parker. ‘Thigh a hit grt, he seems sharp, far direct and willing to give her much job freedom and responsibilty. In fat, her frst assignment is of some importance _and consists of two parts Parker wants Jones to (1) perform a financial evalua- tion on two new machines that he is considering and (2) “ritique” the com- ‘pany’s capital budgeting policies. PLYWOOD PRESSES e ‘The plywood division is an important component ofthe firm's business and. ‘early two entire plants are devoted to the production of plywood panels. In 101130 PARTV CAPITAL BUDGETING venti actin pcos sire ging tine wond wencade Te ee ee Oo redieberet teen n as 2 Seer eer ere ree oc bizar arto noperang iy Ses nape abet Ce eee Co ie ar oat oe Kae once Beet en Se ee ee ees ea epee meter nie ee eee nceeees Se eee a renee eee sesene aa teeeen! eaten ee Bieler perp error Se ee (ote eo eee ees Ce ee ee enero FEE ee ee cad tay aa e PARKER'S FAPG Puertbn vane is cpl algeing practi which be cilsisfoe - can ees gan acter Sepe makes ate pops a Se ce reser apy clued nese one ea i i ealtccanralpepen eth be ae ee tatoaifore censirat”foatomple Par eae sa ec hn toy seal oneness "Ne way Fd do Tee ne eee when duty One sy Seniesa? Ter tundyauliavsten the company re xsl onthe py ae reese ta Pale adda wen Boe cartes apie fo yorsepes andhedcies "uals aE Naz E hanson negbes muchas S100" Bes Peer ey Sastry nerpeclecnipecn he nel perenne Bose te lent tig for more expensive pop cnet oloranon meqsch oe pachacetaen prod serene al wel inpattemse ee wes kt mene We uipieiccuctioampétwaicineandenyiountestcd @ se(CASEI FRANKLIN LUMBER 131 e He alu wants menue ofthe js expected ret and—baed on he suggestion os end with a song tcountng Datu fm eee isthe nvestnensavroge scouting ate of eur (ARB). The AAR determined by dividing the proper average nana net income bys overage Beck ae An oxanpé of ke ARK ptt in bit In orderto be acyl envel ange ivestent must as wo tt Fut, the AAR msteceed th fare book eur Ts bok ea corn 29 percent, he igre tat Paka ee evalse he pero thet pt eenapes Inaadidon, the pets havea acceptable payback” Parker expan -te my fdgment sout what wa ‘acepable’ payback, Therese ne se seine” He ami hough at he dee’ He ose proper payback Eid ve en FORECASTING ACCURACY In Parker's view the most important part ofa capital budgeting decision isthe accuracy ofthe forecasts, and he goes to great lengths to make this clear to the firm’s executives. He constanily reminds them that “forecasters need tobe ‘hon- cst sockers of truth’ ifthe company is to be the bes it can be.” e He monitors the company’s forecasting efforts in two ways. Firs, fa projects ppayback looks “suspiciously low," he personally investigates the forecast Second, from tie to ime Parker has hired outside consultants to compare the actual cash lows of project with those predicted. And ifa set of estimates looks “severely optimistic,” then Parker will question the forecasters, pethaps inten- sively. Ashe putsit, “Thad better receive satisfactory answers to my questions,” Executives who Parker thinks are negligent or allowing personal bias to clouc their udgment facea severe reprimand and even dismissal inone extreme case Parker is aware that many companies are plagued by overly optimistic fore ‘casts, and hes proud of the fact thata postaudit indicated that this has not been ‘rue for Franklin. Infact, there appears to bea tencency forthe forecasts to be too conservative. Tha is, the postaudit showed that on average the predicted cash flowe were less than the actual cach flows. REFLECTIONS ‘Back at her apartment that evening Jones reflected on her meeting with Parker She sees “both good and not so good” with Parker's capital budgeting proce- dures. Perhaps the biggest negative isthe lack of any discounted cashflow tech- ‘nique. Itis clear to Jones, however, that Parker recognizes thatthe 20 percent ta {get retu isa book and not a market rate. Italso appears that Parker is willing e toconsider “capital budgeting techniques based on market returns,” ashe puts it. Conversations with Parker suggest that a 15 percent market retum would be 109tat PARTY CAPITAL BUDGETING scope maps tiisasrarnad anteater pestetat @ chs eceded 8 pra pryee ‘sc glasel the rapoaliyo te sgnmen andi ee to -muendifeece: athe ie time towevr st sb aprcaive iat cnet Post ert ey sre nel vs J snes’ mst onl cae bam tho be ean fied and explained. QUESTIONS: 1. Calculate the annual cash flows of the Dakota (the Nakoi’s cash flow is ‘$255 820 per year, not including its after-tax terminal value). Calculate the Dakota's () payback period () average accountng rate of return (ARR) (© IRR (@) NPV {€) profitability index (PI) NOTE: The table below shows these figures for the Nakoi. e@ Francie States force Nakot Payback 2B yen ‘ARE ee oR Sem Nev sou " 13 '. Rank the plywood presses by the five techniques listed in Question 2. 4 Do the techniques rank the projects the same? Ifnot, why do the rankings differ? 5. Parker's two primary capital budgeting methods are the payback and the average accounting rate of return. (a) What re the disadvantages ofthe payback? What, if any, are its advan- tages (©) What are the disadvantages ofthe AARR? What, if any, are is advan tages? 6. Jones intends to discuss with Parker the net present value and internal rate of return methods. She wants to be well prepared for the meeting and feel that Parker i quite likely to want the following questions addresed. (6) How do you interpret an NPV? an TRR? (©) What are the accept reject criteria foreach? e 08‘CASE21 FRANKLIN LUMBER 133 e (0 What are the advantages ofthe NPV? What if any, are its disadvan- tages? (@) Whatare the advantages ofthe IRR? What fany,aete dlsadvantages? (©) Doesitreally mater which method is used tevaluatea project? Defend your answer 1. Whatarethe advantages ofthe profitability index? What ifany, ae the dis- vantages? 8 Parker apparently spends much time and effort trying to obtain accurate ‘ash flow forecasts. 1s Parker's concern about and attention to these en mates justified? Explain. 9. Any capital budgeting decision involves estimating future cash flows, Financial theory suggests that we want these estimates tobe “unbiased.” Thatis, we want forecasts that are just slikly tobe above as below the sc- tual eash low. Ths, given numerous “unbiased” estimates om average he ‘ash lw forecasts wil equal the actal cash ows. (a) It doesnot appear that Franklin's executives generat “unbiased” fore- casts since a postauit concluded that "on average the predicted cash Flows were es than te actual cash flows.” Are you surprised by thee suo the postaudit? Explain. (©) Suppose that a firm's estimates are consistently too low, Leon average e the predicted cash lows ae below thesctual ash lows, What fica ties any, would this create? ‘10, (a) What do you like about Parker's capital budgeting procedures and why? (©) What do you iste and why? 11, What suggestions would you give Parker regarding his capital budgeting Procedures? Make sure that each suggestion is appropriately justified. 12, Which, if any, ofthe two presses do you recommend that Parker buy? Defend your position SOFTWARE QUESTION 13, (a) Courtney Jones immediately realized that her evaluation would have to te redone. Pete Parker the rms owner and CEO, has revised the formation Jones used to evaluate the plywood presses He now thks that tis more appropiate to asume: 1. The selng (markt pric of plywood increases by & percent per yea 2 Cash costs also increase by & percent per yer. @ 3. Material cos willun’2 percent of les 108334 AKT CAPITAL BUDGETING 4 The appropriate oun ree? pec e 5 othe cana et th igi vals. vate enjoin (Pater fees qt god aout al hie in) exept tbe tw rasin linge pce nd oh cst ral the mache the lowing sear nd kp ll citer eines tte vals wed in 1: Boh gow a3 ponent per yee 2. Both grow at 4 percent per year (actually done in part (a). 5 poh gmat pce pe Js (o Puhr aon theres some posit ah cons wil rae tert ntcing poe relate mace inthe lowing cei nd kp al threats teas edna 1 Sing pre gow a percent pron ah co percent 2 sling pe roe at percent per ou ch cone ret 5 Sling pee rom at 3 percent per ous ch conta erent (based on your mowers) and (0) dows topper hat Pater sold ‘beconcemed about the growth rates hes using? Explain. e EXHIBIT 1 Teformation on the Plywood Presses Nala Dat ‘Out pe day (ue fet) 00 700 MUconcepeequfotsfpywont $180 30 Market pie pr square s Rowman gusta) 7 70 ‘ral 57760 $5000 ‘Anmual maintenance cost sso “Seon00 ‘Arma overeat) sam $0000 ear afetax mare abe 575000 __ $290,000‘CASE21 FRANKLIN LUMBER 135 ‘EXHIBIT 2 Example of the Average Accounting Rate of Return ‘The example asumes that a project's intial cot is depreciated over the life ofthe project ona straight line bass. ee ° 2 etl project cost 8 ‘Accumulated depreciation so 2 4 6 8 ook alse 3 6 4 2 0 Netineome NA ot 202 4 Average Book Value = $4 ‘Average Net Income = $1.50 ‘AARR = 150/4 = 375 = 375%