Case Study In Finance

CASE STUDY IN FINANCE –NOVA TRACTOR CORPORATION

Nova Tractor Corporation owns and operates a transmission and axle plant which manufactures more than 50% of the transmissions and axles used in the complete line of tractors and harvesting equipment offered by Nova 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. 

Nova 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 have gathered relevant purchase prices and 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. 

Table 1: Key Estimates of Financial Data 

The estimates for annual operating costs include the following items:

1. i)  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. 
2. ii)  Salaries for LCC represent the costs of employing two new machine operators at a salary of $40,000 per annum each. For HCC, the company would only need to Employ a new machine operator at a salary of $40,000 per annum and the second, 

Who earns $70,000 per annum, will be transferred from the axle assembly plant. If the transfer is not required, the second operator from the main plant would have been laid off with a redundancy payment of $50,000. 

iii)  The marketing cost is based on the standard allocation of the new investment towards group advertising expenses, which is 10% of annual processed scrap 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.

Nova 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 Nova, is confident that the cost of the chip crusher could be financed with medium-term debt. 

Preliminary discussions with Nova's bankers led Mr Murray to believe that the firm could arrange a 12% 4-year term loan of $400,000 or 6-year term loan of $500,000 for LCC and HCC, respectively. The terms for both loans are repayment of fixed annual interest expense in advance and the principal owing at maturity. The company's tax rate is 30%, and its nominal after-tax cost of capital is 15% per annum. 

The accountant, Mr Peter Smith, pointed out to you that the revenue figures do not take into consideration the scrap sales that Nova would generate if the company did not buy either machine to process the scrap. He has estimated that the current unprocessed scrap would generate a net income of $120,000 per year. 

Production facilities for the steel scrap would be set up in an unused section of Nova'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, Nova 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 $36,000 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 processed 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, Nova's director of capital budgeting, on the risk inherent in Nova's average project and how the company typically would adjust for risk. Frost told you that, the firm has been adding or subtracting 3 percentage points to its 15% 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 judgement of John Newton, 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.

QUESTIONS 

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. 

Which of the following items should be included as incremental cash flows in the table? Give reasons for individual items and list clearly your assumptions in deriving the figures. 

1. a)  Yearly interest expense on the fixed-term loan for each machine; 
2. b)  Working capital investment which is 10% of annual scrap revenue; 
3. c)  Annual operating costs (i.e. overheads, salaries and marketing) for each machine; 
4. d)  The $80,000 that was spent to rehabilitate the plan; 
5. e)  Net income of $120,000 per year from the sales of unprocessed scrap; 
6. f)  Rental income of $36,000 per year. 
7. Which chip crusher (HCC or LCC) would you recommend Nova to purchase based on the 

payback period (PP), internal rate of return (IRR), net present value (NPV) and equivalent annual 

value (EAV) methods? 

[Assume the company is able to invest in both chip crushers on the same terms indefinitely.] 

3. Mr Murray requested risk analysis on the project so it is necessary to check which chip crusher 

(HCC or LCC) made financial sense before it is accepted. 

1. a)  Show a sensitivity analysis of NPVs (derived in Question 2) to changes in annual processed scrap revenue and cost of capital individually. Assume each of these variables can deviate from its estimated value by plus or minus 20%. 
2. b)  Determine how far the annual net operating cash flow could fall short of forecast before the chip crusher would be rejected. 
3. c)  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 2.5% per annum. 
4. Consider all information given in the case study and the results derived in Questions 1 to 3. 

Advise the executive committee and Mr Murray on which chip crusher (LCC or HCC) they should invest. 

5. Discuss the reasons for your recommendation and any reservations you may have in given this advice.

MARKING GUDE QUESTION   MARKS ALLOCATED

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. 

10MARKS EACH = 20MARKS

2. Which chip crusher (HCC or LCC) would you recommend Nova to purchase based on the payback period (PP), internal rate of return (IRR), net present value (NPV) and equivalent annual value (EAV) methods? 

5MARKS EACH = 10MARKS

3. Mr Murray requested risk analysis on the project so it is necessary to check which chip crusher (HCC or LCC) made financial sense before it is accepted. 

20MARKS

4. Consider all information given in the case study and the results derived in Questions 1 to 3. 

Advise the executive committee and Mr Murray on which chip crusher (LCC or HCC) they should invest. 

10MARKS

5. Discussions – clear and relevant suggestions to management. 

10MARKS Presentation, and ELP quality: 

– Quality of document presentation 

– Language, grammar and spelling 

10MARKS

MARKED OUT OF 80 

SCALED TO 40%OF FINAL GRADE

NOTE THAT IN EACH CATEGORY ABOVE, MARKS WILL BE ALLOCATED ON THE BASIS OF ACCURACY OF COMPONENTS WITHIN THE CATEGORY. 

E.G.MARKS WILL BE ALLOCATED FOR EACH ITEM IN YOUR CASH FLOW TABLE. 

THEREFORE IT IS IMPORTANT THAT YOU GIVE A COMPLETE BREAKDOWN OF EACH ITEM WITHIN THE CASH FLOW TABLE.

Introduction:

'Nova Tractor Corporation owns and operates a transmission and axle plant which manufactures more than 50% of the transmissions and axles used in the complete line of tractors and harvesting equipment offered by Nova to the agricultural industry. With an extensive machining process 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.' – As given in the case study. 

This report discusses the options available to the company to invest in two alternatives that will lead to additional income through the sale of scrap steel. As a large quantity of steel is produced as the by-product for the company, the company is looking to invest in one of two machines. Through a detailed financial analysis, the analyst is required to ascertain the best scenario for the company. 

Cash Flow Statement:

As opined by Nurnberg (2006), a cash flow statement is a measure of all the cash inflows and outflows in an organization. Noncash items such as depreciation are not included in an organization's cash flow statements, even though they are critical in determining the net profit or loss of that organization (Sheet, 2010). An organization with net inflows of cash is often deemed to profitable in nature. It implies that the organization is able to generate cash to sustain its business, in the sense that; it can pay off its debts, and even invest in expansion or diversification activities (Nurnberg, 2006). 

two cash flow Statements below (Table 1 & 2), show the projected cash flow statements of Nova Tractor Corporation, with regard to two available options for the company that will help it to generate further cash in the near future. Both the options available to the company have different work lives and different investment requirements. The common factor in both the cash flow statements is that both the options will yield positive cash flows for the organization, and have similar cost structures to them.