Running head: Magic Timber and Steel Investment Evaluation 1

Magic Timber and Steel Investment Evaluation

Student’s Name

Institutional Affiliation
Magic Timber and Steel Investment Evaluation 2

Introduction

The net present method (NPV) is used in investment evaluation to determine which projects

are viable. Projects with a positive NPV are usually favorable compared to others with

negative NPV. Capital spending, net working capital, and operating capital are required to

compute NPV. For Magic Timber and Steel company, NPV is calculated for both new

machine and old machine using an 11% discount rate. The sensitivity analysis requires a

different discount rate, which will be assumed at 12% for both machines and changing the old

machine’s maintenance costs and the fifth year selling price for the new machine. Finally,

NPV estimates that incorporate such changes would help determine whether the company

should purchase the new machine or keep the old one.

NPV using 11% discount rate and 30% tax

After a careful analysis is shown in the Appendix 1, Magic Timber and Steel should purchase

the new machine, Delta A390, since its NPV is positive. In all circumstances, the old machine

(Matrix 750) displays greater expenses than Delta A390, implying procuring a new machine

is cost-effective. However, such a decision cannot solely rely on NPV analysis and other

qualitative and quantitative factors that may affect cash flows. For instance, Delta A390

brings a 40% increase in capacity but requires the company to hire a specialist woodcrafter to

increase revenues. However, to utilize the capacity increase, the company should carry out

market research to determine customer’s expectations regarding new designs.

For the Matrix machine, substantial investment is required for repairs totaling $63,000.

Depreciation amounts to $6,000 annually with a $5,000 salvage value after five years.

Therefore, an investment in Matrix machine is likely to generate fewer revenues.

Qualitative factors
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 The company’s reputation and experience: since the company was established in

1999, Magic Timber has had a successful business. It earned a reputation during the

2002-2004 growth due to appealing customer discount, thus becoming a well-known

supplier.

 Utilizing second-hand machinery: Magic Timber procured a second-hand Scania

truck for logistics purposes. Another second-hand machinery was also acquired even

though the company had the adequate cash flow to procure unused ones.

 Increasing competition and deteriorating economic environment: sales declined

in 2011 due to infrastructure issues. The population plummeted below 4% as tourism

slowed down. Bad debts increased, impacting the company’s financial strength.

Besides, Wesfarmers Ltd established premises nearby hence increasing competition.

 Recent spending: Davidson increased marketing campaigns and introduced a new

product line, steel, to remain competitive. A $300,000 laser cutting machine was

procured.

 New business approach: Davidson minimized the company’s stock level and stocked

only products with huge demand resulting in loss of clients. To survive, he added a

new product line and offered friendly and expert assistance to customers.

Quantitative factors

 New machine, Delta A390: due to decreasing economic growth and low customer

base, the new capacity presented by Delta A390 is not required. The machine costs

$140,000 with 10% annual depreciation on straight-line basis amounting to $70,000

(10% * $14,000 * 5 years). The seller provided fixed pricing for maintenance plan

beginning at $2,000 in the 1st year and growing by $1,000 annually, ($2,000 + $3,000

+ $4,000 + $5,000 + $6,000) = $20,000. Magic acquired a bank loan to finance the
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purchase at a 6% interest rate paid for five years on interest-only repayments and the

principal amount payable in the 5th year. This amounts to $8,400 interest annually.

Delta A390 would be sold for $60,000 in year five.

 Matrix machine repair: requires immediate $28,000 for repair costs and $7,000

spread across five years for regular maintenance totaling $35,000. Matrix machine

requires another $4,000 investment in year three for schedule service.

From this analysis, Magic Timber should consider investing in Delta A390 rather than

repairing the Matrix machine.

Sensitivity analysis (Appendix 2, 3, and 4)

I. NPV using 12% DF

Sensitivity analysis considers different assumptions to comprehend output changes like IRR,

ARR, discounted payback period, and NPV. In appendices 1C and 2C, changing the DF from

11% to 12% impacts output values positively, and increases operational costs by just $138.67,

and decreasing the payback period from 3.36 years to 3.34 years. IRR remains at 15%,

whereas ARR 12%, which is different from DF. However, the profitability index (PI) drops to

2.39 from 2.49. Since the IRR (15%) is higher than DF (12%), Magic should invest in Delta

A390 as DF positively impacts decision which is less sensitive to DF changes.

II. NPV with year five selling price of Delta A390 at $80,000

If the new machine's selling price is changed to $80,000, Magic should invest in Delts A390

since, in Appendix 3A, Matrix's cost is higher at $289,093.62 and Delta's $253,943.67.

Expected annual operating costs for the Matrix are higher than Delta's from 2016-2020;

however, Delta's costs for 2021 increase due to loan principal repayment. In 2021, Magic will

have $35,149.9 net savings if the selling price is $80,000 than the earlier price of $60,000.
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The payback period reduces to 2.99 years from 3.36 years, IRR for ARR for Delta 21% and

22% while IRR and ARR for Matrix 15% and 12% respectively.

III. NPV with Delta’s maintenance costs at $1,000 year 1 and $1,000 annual

increase.

In this situation, PV for total costs amounts to $255,230.46. The amount is lower than

Matrix's costs by $33,863.16. For Delta, operating costs will be fewer in the first four years

averaging $7,589.35 annually; however, the amount will increase in 2021 to $57,297.97 due

to loan repayment, surpassing Matrix's $41,213.74 annual costs. The payback period

increases to 3.10 years but is still lower than 3.36 years for Matrix. Delta's IRR and ARR

equals 18% and 16%, which is better than Matrix's.

IV. NPV after combining factors I, II, III

Delta Machine is still the best option after combining all three factors. Savings amount to

$37,556.33, which is the highest in all sensitivity analyses. Davidson's annual operating costs

will be lower with Delta machine since Matrix requires annual maintenance and year three

service costs. This scenario presents a 2.80 years payback period, which is lower and proves

purchasing the new machine is a viable investment. IRR and IRR are also high at 23% and

25%; thus, Delta A390 is an attractive and profitable option.

Recommendation.

Davidson should purchase Delta A390, which will boost capacity by 40%. The machine will

require him to employ a specialist woodcrafter, which is projected to increase revenues. Thus,

he can manage to pay off loan interest and principal amount. The Matrix requires huge

maintenance costs than Delta. Hence, purchasing the new machine seems a viable move since

Magic Timber and Steel can remain competitive and solvent with changing business trends.
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Appendix 1
Appendix (A).

Appendix (B).

Appendix (C).
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Appendix (D).

Appendix 2: Discount factor 12%

Appendix (A).
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Appendix (B).

Appendix (C).
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Appendix (D).

Appendix 3
Appendix (A).

Appendix (B).
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Appendix (C).

Appendix 4
Appendix (A).

Appendix (B).
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Appendix (C).