Case study: Capital Budgeting in relation to decision on putting in a bid for Heavy-Duty Tractors.

Diversified Industries is a large conglomerate and is continually in the market for new acquisitions. The company has grown rapidly over the last 10 years through buyouts of medium-size companies. Diversified does not limit itself to companies in any one industry but looks for firms with a sound financial base and the ability to stand on their own financially. The president of Diversified recently told a meeting of the companys officer: I want to impress two points on all of you. First, we are not in business of looking for bargains. Diversified has achieved success in the past by acquiring companies with the ability to be a permanent member of the corporate family. We dont want companies that may appear to be a bargain on paper but cant survive in the long run. Second, a new member of our family must be able to come in and make it on its own the parent is not organized to be a funding agency for struggling subsidiaries. Ron Dixon is the vice president of acquisitions for Diversified, a position he has held for five years. He is responsible for making recommendations to the board of directors on potential acquisitions. Because you are one of his assistants, he recently brought you a set of financials for a manufacturer, Heavy-Duty Tractors, Inc. Dixon believes that Heavy-Duty is a cant-miss opportunity for Diversified and asks you to confirm his hunch by performing basic financial statement analysis on the company. The most recent comparative balance sheets and income statement for the company follow: Dec 31,2007 Assets Current assets: Cash Marketable securities Account receivable, net of allowances Inventories Prepaid items Total current assets Long term investment Property, plant, and equipment: Land Building and equipment, less accumulated depreciation Of $385,000 in 2007 and $325,000 in 2006 Total property, plant, and equipment Total assets $45,000 545,000 $590,000 $970,010 $45,000 605,000 $650,000 $921,070 $48,500 3,750 128,420 135,850 7,600 $324,120 $55,890 $24,980 0 84,120 96,780 9,300 $215,180 $55,890 Dec 31, 2006

Liabilities and Stockholders Equity Current Liabilities:

Short-term notes Accounts payable Salaries, wages, and other Income taxes payable Total current liabilities Long-term bonds payable, due 2014 Stockholders equity: Common stock, no par Retained earnings Total stockholders equity Total liabilities and stockholders equity

$80,000 65,350 14,360 2,590 $162,300 $275,000

$60,000 48,760 13,840 3,650 $126,250 $275,000

$350,000 182,710 $532,710 $970,010

$350,000 169,820 $519,820 $921,070

Heavy-Duty Tractors Inc. Statement of Income and Retained Earnings For the Year Ended December 31, 2007 (thousands omitted) Sales revenue Cost of goods sold Gross profit Selling, general, and administrative expenses Operating income Interest expense Net income before taxes and extraordinary items Income tax expense Income before extraordinary items Extraordinary gain, less taxes of $6,000 Net income Retained earnings, January 1, 2007 $875,250 542,750 $332,500 264,360 $68,140 45,000 $23,140 9,250 $13,890 9,000 $22,890 169,820 $192,710 Dividends paid on common stock Retained earnings, December 31, 2007 10,000 $182,710

What will you tell your boss? Should he recommend to the board of directors that Diversified put in a bid for Heavy-Duty Tractors?

CASE STUDY
COST SAVING PROPOSAL

Swastik Limited manufacturers of special purpose machine tools have two divisions which are periodically assisted by teams of visiting consultants. The management is worried about the study increase of expenses in this regard over the years. An analysis of the last year expenses reveals the following:

Consultants Remuneration Travel and Conveyance Accommodation expenses Boarding Charges Special Allowances

Rs. 250000 Rs. 150000 Rs. 600000 Rs. 200000 Rs. 50000

The management estimates accommodation expenses to increase by Rs. 200000 annually. As part of cost reduction drive Swastik Limited is proposing to construct a consultancy centre to take care of the accommodation requirements of the consultants. This centre will additionally save the company Rs. 50000 in boarding charges and Rs. 200000 cost of executive training program hitherto conducted outside the company premises every year. The following details are available regarding the construction and maintenance of the new centre. a) Land at a cost of Rs. 800000 already owned by the company will be used. b) Construction Rs. 1500000 including special furnishing. c) Cost of annual maintenance Rs. 150000 d) Construction cost will be written off (at a uniform rate) over five years being the useful life. Assuming that the write off of the construction cost as aforesaid will be accepted for tax purposes, that the rate of tax will be 35% and that the desired rate of return is 15%. You are required to analyze the feasibility of the proposal and make recommendations.

Sugar Cane Irrigation: A Case Study in Capital Budgeting

1. 2.

McKinsey & Company, Inc., San Francisco McKinsey & Company, Inc., San Francisco

Abstract
A study of irrigation, economics was conducted in 1963 on a 10,000 acre sugar plantation in Hawaii and repeated in 1964 on three additional plantations covering 34,000 acres. The objective of the study was to recommend, on an agronomic and economic basis, a program for investing large amounts of capital in newly developed automatic and semi-automatic irrigation systems. Although basically a problem in capital budgeting, a number of complicating factors precluded the straightforward application of traditional investment analysis techniques. The more important of these factors were: 1. Many Alternatives. The wide range of physical conditions found on each plantation ruled out the selection of a single best irrigation system. As a result, a number of systems had to be evaluated for each of several hundred cane fields. 2. Combinatorial Aspects. Investments in individual cane fields were interdependent since groups of fields shared common water sources; thus, combinations of investments had to be analyzed, increasing the number of investment alternatives astronomically. 3. Opportunity Value of Scarce Resources. New irrigation systems offered substantial water savings. However, the value of these savings arises from the opportunity value of water in alternative uses. Alternative uses, in turn, depend on how much water is saved. Thus, no value for potential savings on the plantation could be established until the investment analysis was run, first for individual alternatives and then for combinations of alternatives. 4. Complicated Timing. Because of crop planting schedules, new systems would be installed on small increments of acreage over a period of 8 to 10 years. Thus, nonconventional investments (outlays interspersed with benefits such that the stream of cash flows had multiple sign changes) occurred in multiple time periods; furthermore, because of crop harvesting schedules, returns from these investments also were distributed over multiple time periods with varying amounts of delay between investments and returns. The approach used to solve this problem is described in the paper