Capital Budgeting Case - Barrister Industries
You are the division finance manager for Barrister Industries, a publicly traded manufacturing company. The division head comes to you very excited, because he just met with a new customer that wants Barrister to be the sole source manufacturer of a key component for one of its current, well selling products. The division head asks you to prepare a financial analysis of whether Barrister should pursue this opportunity.
You discuss the situation with the sales manager and learn that the customer intends to purchase the part from Barrister for the next five years, and will agree to a firm contract for the first three years.
Under this contract, the customer will purchase 20,000 units the first year, followed by 25,000 units in years 2 and 3. After that, the customer has forecasted additional unit purchases of 20,000 in year 4 and then 15,000 units in the last year.
Following that, any additional purchases are highly uncertain, but could be for a total additional units of 10,000. The unit selling price is expected to be $30 the first year, but should increase 5% each year thereafter due to expected inflation . Credit terms for the new customer will be net 30 days.
You next visit with the manufacturing manager for the division who says Barrister would have to purchase new tooling and machinery in order to make the part the customer wants. He estimates that the new equipment needed will cost $500,000 plus another 5% for shipping and installation. After further discussion with him, you learn that the additional raw materials inventory can be financed with trade credit from suppliers for 30 days. It should take 30 days to complete the manufacturing process from when the raw materials arrive. Shipments (sales) of finished goods to the new customer will be immediate upon completion of manufacturing.
The new equipment would be depreciated using a 7 year MACRS life and you may assume Barrister will retain the tooling after the project’s life.
From manufacturing’s estimates of unit product costs, gross profit on each unit sold will be 45% of sales. Annual selling expenses will be 10% of sales and additional general and administrative expenses are expected to be $20,000 each year to manage this project.
The tax rate to be used is 35%. Corporate headquarters has established the guideline that divisions to use risk adjusted hurdle rates (cost of capital) when analyzing investments. Specifically, for less risky projects (e.g., for equipment replacement decisions) a 15% discount rate is to be used. A 20% discount rate is used for more risky projects, (e.g., sales expansion projects). They expect the divisions to select and justify the discount rate used in any analysis. Also, Barrister’s corporate finance department provides the suggested format for 5 year cash flow analysis for analyzing any investment request cash flows. Requirements: Complete a financial analysis for this new business opportunity using discounted cash flow methods covered in capital budgeting, i.e., net present value, IRR, and MIRR. The reinvestment rate used for MIRR is 12%. Prepare the analysis in presentable form for the division head, including a written section that makes your recommendation of whether Barrister should pursue this business and submit the proposal to headquarters for approval. Also, include suggestions to the division head of what might be done to improve the business case for proceeding with this opportunity and obtaining approval for the required investment. template attached go to barrister week 6
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