Analysis of a Business Venture
A small group of investors is considering starting a small premixed- concrete plant in a
rapidly developing suburban area about 15 miles from a large city. The group believes
that there will a good market for premixed concrete in this area for at least the next 10
years and that if they establish such a local plant, it will be unlikely that another local
plant would be established. Existing plants in the adjacent large city would, of course,
continue to serve this new area. The investors believe that the plant could operate at
about 75% of capacity 250 days per year, because it is located in an area where the
weather is mild throughout the year.
The plant will cost $100,000 and will have a maximum capacity of 72 yard3 /day. Its
market value at the end of 10 years is estimated to be $20,000, which is the value of the
land. To deliver the concrete, four secondhand trucks would be acquired, costing $8,000
each, having an estimated life of five years and a market value of $500each at the end of
that time. In addition to four truck drivers, who would be paid $50.00 per year each,
four people would be required to operate that plant and office at a total cost of
$175.00/day. Annual operating and maintenance expenses are estimated for the plant
and office at $7,000 and for each truck at $2,250, both in view of 75%capacity
utilization. Raw material costs are estimated to be $27.00 per cubic yard of concrete.
Payroll taxes, vacations, and other fringe benefits would amount to 25% of the annual
payroll. Annual taxes and insurance on each truck would be $500, and taxes and
insurance on the plant would be $1,000/year. The investors would not contribute any
labor to the business, but a manager would be employed at an annual salary of $20,000.
Delivered, premixed concrete is currently selling for an average of $45 per cubic yard. A
useful plant life of 10 years is expected, and capital invested elsewhere by these
investors is earning about 15% per year before income taxes. It is desired to find the
AW for the expected conditions desired and to perform sensitivity analysis for certain
factors.
Annual Worth of Proposed Plant at Expected Conditions
Annual revenue: 72*250*$45*0.75=$607,500.
Annual expenses:
1. Capital recovery amount:
Plant: $100,000(A/P, 15%, 10) - $20,000(A/F, 15%, 10) = $18,940
Trucks: 4[$8,000(A/P, 15%, 10) - $500(A/F, 15%, 10)] = $9250.
Capital recovery= $28,190
2. Labor:
Plant and office: $175*250= $43,750
Truck drivers: 4*$50*250= $50,000
Manager: $20,000
Annual labor cost= $ 113,750
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3. Payroll taxes, fringe benefits, and so on: $ 113,750 * 0.25 = $28,438
4. Taxes and insurance:
Plant: $1,000
Trucks: $500*4 = $ 2,000
Annual taxes and insurance: 1,000+ 2,000 = $3,000
5. Operations and maintenance at 75% capacity:
Plant and office: $ 7,000
Trucks: $2,250*4 = 9,000
Annual Operations and maintenance cost = $16,000
6. Material: 72*0.75*250*$27 = $ 364,500
Total expenses $553,878
The net AW for these most likely (best) estimates is $607,500-$553,878= $53,622.
Apparently, the project is an attractive investment opportunity.
In this case study, there are three factors that are of great importance and that must be
estimated:
1. Capacity utilization
2. The selling price of product
3. The useful life of the plant.
A fourth factor – raw material costs- is important, but any significant change in this
factor would probably have an equal impact on competitors and probably would be
reflected in a corresponding change in the selling price of mixed concrete. The other
cost elements should be determinable with considerable accuracy. Therefore, we need
to investigate the effect of variations in the plant utilization, selling price, and useful life.
Sensitivity analysis is needed in this situation.
Sensitivity to capacity utilization:
As first step, we will determine how expenses would vary, if at all, as capacity utilization
is varied. In this case it is probable that the annual expenses items listed under groups 1,
2,3 and 4 in the previous tabulation would be virtually unaffected if capacity utilization
should vary over a quite wide rang-from 50 to 90% for example. To meet peak demand
the same amount of plant, trucks, and personal probably would be required. Operations
and maintenance expenses (group 5) would be affected somewhat. For this factor, we
must try to determine what the variation would be or make a reasonable assumption as
to the probable variation. For this case, it will be assumed that one-half of these
expenses would be fixed and the other half would vary with the capacity utilization by a
straight line relationship. Certain other factors, such as the cost of materials in this case,
will vary in direct proportion to capacity utilization.
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Using these assumptions, Table 1 shows how the revenue, expenses and net AW would
change with different capacity utilizations. It will be noted that AW is moderately
sensitive to capacity utilization. The plant could be operated at a little less than 65% of
capacity, instead of the assumed 75%, and still produce an AW greater than zero. Also,
quite clearly, if they can operate above the assumed 75% capacity, AW would be very
good. This type of analysis gives the analyst a good idea of how much leeway the
company has in capacity utilization and still has an acceptable venture.
Table 1. AW at i =15% per year for the premixed- concrete plant for various capacity
utilizations ( Average selling price is $45 per cubic yard)
50% capacity
65% capacity
90% capacity
Annual revenue
$ 405,000
$ 526,500
$729,000
Annual expenses
Capital recovery
28,190
28,190
28,190
labor
113,750
113,750
113,750
Payroll taxes and
28,438
28,438
28,430
similar items
Taxes and insurance 3,000
3,000
3,000
Operation and
13,715
15,086
17,372
maintenance
Material
243,000
315,900
437,400
Total expenses
430,093
504,364
628,150
AW (15%)
-25,093
22,136
100,850
Table 2. Effect of various selling prices on the AW for the premixed-concrete plant
operating at 75% of capacity
Selling Price
$45.00
43.65(3%)
42 .72 (5%)
40.50(10%)
Annual revenue
607,500
589,275
577,125
546,750
Annual
553,878
533,878
553,878
553,878
expenses
AW (15%)
$ 53,622
$ 35,397
$23,247
- $7,128
Sensitivity to selling price:
Examination of the sensitivity of the project to the selling price of the concrete reveals
the situation shown in table 2. The values in this table assume that the plant would
operate at 75% of capacity; the expenses would thus remain constant, with only the
selling price varying. Here it will be noted that the project is quite sensitive to price. A
decrease in price of 10% would reduce the IRR to less than 15% (AW<0). Because a
decrease of 10% is not very large, the investors would want to make a thorough study of
the price structure of concrete in the area of the proposed plant, particularly with
respect to the possible effect of the increased competition that the new plant would
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create. If such a study reveals price instability in the market for concrete, the plant could
be a risky investment.
Sensitivity to useful life:
If a life of five years were assumed for the plant, instead of the assumed value of 10
years, the only factors in the study that would be changed would be the cost of capital
recovery. If the market value is assumed to remain constant, the capital recovery
amount over a five-year period is:
$100,000(A/P, 15%, 10) - $20,000(A/F, 15%, 10) = $26,866 per year.
This is $7,926 more expensive than the initial value of $18,940. In the case, AW would
be reduced to $45,696-a decline of 14.8%. Hence, a 50% reduction in useful life causes
only a 14.8% reduction in AW. Clearly, the venture is rather insensitive to the assumed
useful life of the plant.
With the added information supplied by the sensitivity analysis that have just been
described, those who make the investment decision concerning the proposed concrete
plant would be in a much better position than if they had only the initial study results,
based on assumed utilization of 75% of capacity available to them.
Case study Exercises:
1. Redo the previous case study using graphical tools instead of tabulated analysis.
2. Develop an appropriate sensitivity graph (spider plot) for this analysis. Include
any additional values of the factors you consider necessary. Also, include raw
material costs as additional factors in the sensitivity graph, under the
assumption that all competitors may not respond to changes in these costs the
same way.
3. For the three most sensitive factors, further analyze the combined effect of their
outcomes on the AW. You must determine how to best formulate the
combination of factor outcomes. You can develop three or four scenarios with
selected changes in specific factors.
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