GB519 Unit 10 Capital Budgeting Decision Package Example

A Second Fabrication Cell for a Children's Hospital Network: A Unit 10 Capital Budgeting Decision Package

[Student Name]

Purdue University Global

GB519: Measurement and Decision Making

Unit 10 Capital Budgeting Decision Package

[Instructor Name]

[Date]

The lab, the hospital network and every figure are composite and illustrative; the methods and sources cited are real.

Part 1: Decision Summary

Request: $820,000 for a second fabrication cell (a five-axis mill, a large-format 3D printer, a thermoforming oven and four finishing benches) plus $90,000 of working capital.

Purpose: supply custom pediatric ankle-foot orthoses and related devices to a children's hospital network that has offered Fernhill a five-year supply agreement.

Recommendation: approve, on condition that the network's agreement commits to at least 1,450 devices a year from the second year.

The three figures: net present value of about $284,950 at Fernhill's 11 percent hurdle rate; internal rate of return of about 18.7 percent; payback in about 4.1 years.

Main risk: the value depends heavily on volume. If the network sends about 21 percent fewer devices than planned, the net present value falls to zero.

Part 2: Assumptions Register

Every figure below carries its origin, so that the owner can challenge any one of them.

Installed cost, $820,000: quotes from the mill and printer suppliers, plus the electrician's estimate for the added oven circuit.

Working capital, $90,000: about two months of the network's billings at full volume, on its 60-day payment terms, plus materials stock; recovered at the end.

Volume: 1,800 devices a year at full volume, from the network's letter of intent; 50 percent in the first year and 80 percent in the second while its clinics move their patients over, full volume from the third year.

Contribution, $250 a device: a contract price of $415 less about $165 of materials, technician time and variable overhead, the incremental cost found for pediatric AFOs in the Unit 4 job costing work.

Added fixed cost, $110,000 a year: one digital modeler, a maintenance contract for the new mill and printer, and the expanded lease.

Life and salvage: seven years, with $60,000 of resale value at the end.

Depreciation: straight-line, about $108,571 a year, for the purpose of estimating tax.

Tax rate: 25 percent.

Hurdle rate: 11 percent, the rate Fernhill's owner and lender use for expansion projects.

Graham and Harvey (2001) found that most companies rely on discounted measures for decisions like this one, but that many also look closely at payback; this package reports all three.

Part 3: Cash Flows and Discounting

Annual cash flow is contribution less added fixed cost, after tax, with depreciation added back because it is not a cash payment.

Year 0: negative $910,000, the installed cost and working capital.

Year 1: 900 devices; contribution $225,000; operating income after depreciation $6,429; cash flow $113,393.

Year 2: 1,440 devices; contribution $360,000; operating income $141,429; cash flow $214,643.

Years 3 to 6: 1,800 devices; contribution $450,000; operating income $231,429; cash flow $282,143 each year.

Year 7: $282,143 plus the return of $90,000 of working capital and $60,000 of salvage, or $432,143.

Discounted at 11 percent, the present values are about $102,156, $174,209, $206,300, $185,856, $167,438, $150,845 and $208,145, for a total of about $1,194,950. Less the $910,000 investment, net present value is about $284,950. Discounting at about 18.7 percent would bring the total to zero, so that is the internal rate of return. Cumulative cash turns positive during the fifth year, about 4.1 years after purchase.

Brealey et al. (2023) note that net present value is the measure most closely tied to the owner's wealth, because it gives, in present dollars, the gain left over once the required return has been earned. A positive figure of about $285,000 means the cell is expected to earn its 11 percent and add that much beyond it.

The cell's value rests mostly on volume: it survives a 20 percent shortfall with almost nothing to spare and is lost at about 21 percent.

Part 4: Sensitivity

Each input was changed alone while the others held at their base values.

Volume 10 percent higher: net present value about $423,305.

Volume 10 percent lower: about $146,594.

Volume 20 percent lower: about $8,239.

Break-even volume: about 79.4 percent of plan, or about 1,429 devices a year at full volume.

Contribution $225 instead of $250: about $146,594. Contribution can fall to about $198.50 a device before value is lost.

Added fixed cost 10 percent higher, $121,000 a year: about $246,074.

Volume and contribution matter far more than fixed cost. A 10 percent change in either moves net present value by about $138,000; the same change in fixed cost moves it by about $39,000. That is why the recommendation's condition is a volume commitment, and why the contract price should include an annual adjustment for materials costs.

Part 5: The Managerial Accounting View

# Break-Even and Cost Structure

The cell adds about $218,571 a year of fixed cost, $110,000 in cash and $108,571 of depreciation. At $250 of contribution, it covers its own fixed cost at about 874 devices a year, less than half of full volume. In year one, at 900 devices, it barely does: operating income from the cell is only about $6,400.

The cell also makes Fernhill's profit more sensitive to volume. With more of its cost fixed, the lab's profit will rise faster when volume is strong and fall faster when it is weak. Garrison et al. (2021) describe this trade-off as the price of capacity: fixed cost buys the ability to grow, but it narrows the margin of safety until the volume arrives.

# Effect on Next Year's Budget

If the cell is approved for installation early next year, the master budget changes in three ways. Revenue rises by about $373,500 from the network's 900 devices. Fixed overhead rises by $110,000 and depreciation by about $108,571. Working capital absorbs $90,000, mostly in receivables, because the network pays on 60-day terms.

The financing deserves separate attention from the investment decision. The mill supplier offers an equipment loan for 70 percent of cost. The remaining $246,000 and the working capital could be paid in the second quarter, after the year-end credit line is repaid, so that the cell's spending does not land during the fourth-quarter cash squeeze.

# Effect on the Scorecard

Three scorecard measures change. Hospital systems' share of revenue should rise from 30 percent toward 40 percent once the network reaches full volume, well past the current target of 34 percent. Two new rows should be added for the network's account during the first two years: its remake rate on pediatric devices and its days from scan to shipment. Kaplan and Norton (1996) recommend that a major investment carry measures of its own, so the owner can see early whether the causal bet behind it is working.

Risks

Concentration: the network would become Fernhill's largest customer, at about 15 percent of revenue once at full volume. A five-year agreement with a volume commitment reduces but does not remove that exposure.

Payment rates: much pediatric care is paid by public insurance, whose rates for custom orthoses change slowly and sometimes fall. A lower rate would press the network to renegotiate the $415 price.

Staffing: the cell needs a modeler and technicians trained for pediatric work. The cross-training initiative in the scorecard should start before installation.

Technology: 3D printing of orthoses is improving quickly, and a cheaper printer in three years could lower a competitor's cost. The salvage value assumes the mill keeps a resale market.

Post-Audit

At twelve and twenty-four months, the controller should compare actual devices, contribution per device, added fixed cost and remake rate on the network's account with the assumptions in Part 2. Any gap should be explained in the same way as a variance: by cause, with a role responsible for confirming it. A post-audit improves future requests as much as it checks this one, because it shows which assumptions Fernhill tends to make too optimistic.

Conclusion

The cell earns its 11 percent with a margin of about $285,000, and its managerial accounting effects are manageable: a thin first year, profit more sensitive to volume and a working capital need that can be timed around the year-end squeeze. Its weakness is dependence on one customer's volume. Approval should therefore depend on a written commitment of at least 1,450 devices a year from the second year, a materials price adjustment in the contract, and a post-audit at twelve months.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2023). Principles of corporate finance (14th ed.). McGraw Hill.

Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2021). Managerial accounting (17th ed.). McGraw Hill.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Kaplan, R. S., & Norton, D. P. (1996). The balanced scorecard: Translating strategy into action. Harvard Business School Press.