CASE STUDY
Cisco Tractor Corporation1
Cisco Tractor Corporation owns and operates a transmission and axle plant which
澳洲dissertation網manufactures more than 50 percent of the transmissions and axles used in the complete line of tractors and harvesting equipment offered by Cisco to the agricultural industry. With an extensive machining processes performed on the steel parts for the final transmission and axle assembly, a very large amount of steel shavings and bulky steel scrap is generated in this plant. The unprocessed steel scrap is sold as a by-product of the manufacturing operation to various firms involved in the recycling process.

The executive committee is currently evaluating whether to process the scrap into different grades and types of usable steel. Using different models of chip crushers, the scrap is grinded and compressed into either “rough” or “fine” scrap. The fine scrap fetches a higher market price than the rough scrap. Cisco has to decide whether to invest in the higher-cost chip crusher (HCC) to produce fine scrap or the lower-cost chip crusher (LCC) to produce rough scrap.

As a financial analyst of the company, you had gathered relevant purchase prices and
http://www.400190.com/dissertation_writing/Accounting/operating costs of the two chip crushers from the supplier of the chip crushers and the
marketing and production staff. Key estimates of financial data for the two machines are shown in Table 1.

The estimates for annual operating costs include the following items:
a) The overheads include direct operating expenses incurred in the production of the fine or rough scrap and a fixed amount of $30,000 per annum to cover the Head Office overheads.

b) Salaries represent the costs of employing two new machine operators at a salary of
$40,000 per annum each. For machine HCC, the company would only need to employ a new machine operator and the second, who earns $70,000 per annum, will be transferred from the axle assembly plant. The second operator from the main plant would otherwise have been laid off with a redundancy payment of $50,000.

c) The marketing cost is based on the standard allocation of the new investment towards group advertising expenses, which is 10% of annual revenue. It has been estimated that the additional group advertising required promoting the sales of fine or rough scrap is only $40,000 per year.

Cisco is a private company, soundly financed and consistently profitable. Cash and deposits are not sufficient to buy the chip crusher. However, Mr Jack Murray, the Chairman of Cisco, is confident that the cost of the chip crusher could be financed with medium-term debt. Preliminary discussions with Cisco’s bankers led Mr Murray to believe that the firm could arrange a 12 percent 4-year term loan of $400,000 for either machine with repayment of fixed annual interest expense in advance2 and the principal owing at maturity. The company’s tax rate is 30 percent, and its nominal cost of capital is 15 percent per annum.#p#分頁標題#e#

The accountant, Mr Peter Smith, pointed out to you that the revenue figures do not take into consideration the scrap sales that Cisco would generate if the company did not buy either machine. He has estimated that the current unprocessed scrap would generate a net income of $100,000 per year.

Production facilities for the steel scrap would be set up in an unused section of Cisco’s main plant. The section of the plant where the steel scrap production would occur has been unused for several years, and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, Cisco spent $80,000 to rehabilitate that section of the main plant. Smith believes this outlay, which has already been paid and expensed for tax purposes, should be charged to the steel scrap project. His contention is that if the rehabilitation had not taken place, the firm would have to spend $80,000 to make the site suitable for the steel scrap project. As the section of the plant has been rehabilitated, it could fetch a rental income of $40,000 per year.

Murray wanted to see some type of risk analysis on the project as it might be profitable, but what are the chances that it might turn out to be a loser. You met with the marketing and production managers to get a feel for the uncertainties involved the cash flow estimates. After several sessions, they concluded that there was little uncertainty in any of the estimates except for sales, which could vary widely. Past contracts agreed upon with several dealers indicate the future revenues from the sales of steel scrap could be higher or lower than the marketing staff had anticipated, depending on the market demand. In their opinion, the revenue projections for both LCC and HCC could deviate from its estimated values given in Table 1 by plus or minus 20%.

You also discussed with Andrew Frost, Cisco’s director of capital budgeting, on the risk inherent in Cisco’s average project and how the company typically adjust for risk. Frost told you that, the firm has been adding or subtracting 3 percentage points to its 15 percent overall cost of capital to adjust for differential project risk. When you asked about the basis for the 3- percentage point adjustment, Frost stated that it apparently had no basis except the subjective judgment of Peter Smith, a former director of capital budgeting who was no longer with the company. Therefore, may be the adjustment should be 2 percentage points or may be 5 percentage points.

Given the uncertainties in sales, the plant manager, Mr Mark Lacy, favours the lower-priced LCC. Lacy argues that the company is better off using the $80,000 price differential for investment in another independent project. This project with $80,000 investment outlay is expected to yield an internal rate of return of 25% over a 5-year economic life. In addition, the tax authorities allow the investment outlay to be depreciated on a straight-line basis toward a zero estimated salvage value.

QUESTIONS#p#分頁標題#e#
1. Prepare the cash flow table (which incorporates taxes and includes initial investment, operating and terminal cash flows) for each chip crusher using the information given in the case. Explain if each of the following items should be included in the cash flow table. List clearly your assumptions in deriving the figures.
a) Yearly interest expense on the $400,000 term loan;
b) Working capital investment which is 10% of annual scrap revenue;
c) Annual operating costs (i.e. overheads, salaries and marketing) for each machine;
d) The $80,000 that was spent to rehabilitate the plan;
e) Net income of $100,000 per year from the sales of unprocessed scrap;
f) Rental income of $40,000 per year.

2. Using the cash flows from Question 1, which chip crushers (LCC or HCC) would you recommend Cisco to purchase based on the payback period (PP), net present value (NPV) and internal rate of return (IRR) methods?

3. It is necessary to check if the chip crusher made financial sense before it is accepted.
a) 澳洲dissertation網Show a sensitivity analysis of NPVs (derived in Question 2) to scrap revenue and
cost of capital. Assume each of these variables can deviate from its estimated value by plus or minus 20%.
b) You wondered just how far the annual net operating cash flow could fall short of
forecast before the chip crusher would be rejected.

4. Consider the recommendation by the plant manager to purchase LCC and to invest in the $80,000 project. Assume the company is able to invest in this project on the same term indefinitely, and this project and HCC are mutually exclusive. Would you recommend Cisco to purchase LCC and to invest in the $80,000 project?

5. After reviewing the data provided, you realised the revenue and cost figures have not been adjusted for inflation which is another source of uncertainty. Some people were talking about a zero long-term inflation rate, but you wondered what would happen if inflation is 3% per annum.

6. Consider all information given in the case study and the results derived in Questions 1 to 5. Advise the executive committee and Mr Murray on whether they should invest in one of the two chip crushers (LCC or HCC). Discuss the reasons for your recommendation and any reservations you may have in given this advice.