Nova Tractor Corporation

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.

2. Yearly interest expense on the fixed-term loan for each machine;

• Working capital investment which is 10% of annual scrap revenue; 
• Annual operating costs (i.e. overheads, salaries and marketing) for each machine; 
• The $80,000 that was spent to rehabilitate the plan; 
• Net income of $120,000 per year from the sales of unprocessed scrap; 
• Rental income of $36,000 per year. 

3. 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.]

4. 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. 

5. 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%. 

6. Determine how far the annual net operating cash flow could fall short of forecast before the chip crusher would be rejected. 

7. 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. 

8. 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. 

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

In this report, we looked at the Nova Tractor case study. Nova had to decide whether it was good to invest in the HCC in order to produce fine scrap or LCC in order to produce rough scrap. In section 1, some calculations and assumptions were done before calculating cash flow from operations which applies to both LCC and HCC. After that cash flow table was prepared to utilize all assumptions and calculations. In section 2, capital budgeting decisions were made using different methods such as the internal rate of return method, the net present value method, payback period method, and the equivalent annual value method. In section 3, before accepting any project, Mr. Murray risk analysis was done on both projects in order to know the finance sense. First, the cost of capital was decreased or increased by 3% without effecting processed scrap revenue in order to look at the change in NPV value. Second, the processed scrap revenue was decreased or increased by 20% without affecting the cost of capital in order to look at the change in NPV value. Third, the real interest rate was calculated using the inflation rate and cost of capital. The same real interest rate was considered as the new cost of capital and recalculated NPV value using the new cost of capital without effecting processed scrap revenue. Looking at the results of section 1 to 3, the executive committee and Mr. Murray should invest on the HCC i.e. Higher-cost chip crusher in order to produce fine scrap. The NPV is the best method to make capital budgeting decisions. It was found out that NPV of HCC was higher than that of LCC. When the cost of capital and processed revenue was decreased or increased, it was found that NPV would increase with the decrease in the cost of capital and increase in processed scrap revenue.

Introduction

Nova Tractor corporation produces transmissions and axles assembly that is used for tractors and harvesting purpose. The unprocessed scrap is sold in the market as a by-product. Now, the executive committee is thinking whether to use the unprocessed scrap to make fine or rough scrap. Different capital decision methods were used to find out whether the Nova should invest in the HCC i.e. higher cost chip crusher in order to produce fine scrap or LCC i.e. lower-cost chip crusher to produce rough scrap.  For this purpose, Nova has decided to use the steel scrap section of the main plant. This was rehabilitated one year back with an investment of $80,000. The lifespan of HCC is for 6 years while the life span of LCC is for 4 years. Using different capital budgeting techniques like IRR, NPV, payback period and EAC method, the best investment decision was found out. 

Findings and Discussion

Section 1: Cash Flow table

Before calculating the cash flow from operations, some calculations and assumptions were done which applies to both HCC and LCC.

• Depreciation of the machine for each year was calculated using the reducing balance method.
• The unprocessed scrap revenue per year was taken as the cost of goods sold as it was used as a raw material for making fine scrap or rough scrap.
• Overhead expenses were taken excluding head office overheads.
• Salaries expense was taken as operating expense 
• Advertising cost as promotional sales was estimated to be 10% of annual scrap revenue and was considered as operating expenses.
• Simple Interest for each year was calculated by multiplying the principal value with the rate of interest i.e. 12% (given).
• The working capital was estimated to be 10% of annual scrap revenue.
• The cost of capital was taken as 15%.
• Tax rate was taken as 30%.
• The cost of rehabilitation of the site was considered as an initial investment.