FIN 320 Module 6 Capital Budgeting Analysis example

Faster Turns, Freed Cash: A Capital Budgeting Analysis of an Automated Distribution Center for a Composite Pet Supply Retailer

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FIN 320: Principles of Finance

Module Six Assignment

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The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Faster Turns, Freed Cash: A Capital Budgeting Analysis of an Automated Distribution Center for a Composite Pet Supply Retailer

The Proposal

Brightwater's current regional warehouse relies on manual picking and ships most orders to stores weekly. Management proposes replacing it with an automated distribution center, costing 38 million dollars installed, that would pick and ship orders daily. Daily replenishment would let stores hold less stock, directly addressing the inventory build identified earlier in this project. The investment deserves approval only if it returns more than Brightwater's weighted average cost of capital of about 9.5 percent, estimated in Milestone Two, since the project's risk resembles that of the company's existing operations (Ross et al., 2022).

Cash Flow Assumptions

Only incremental cash flows, those that occur because of the project, are counted. Annual pre-tax savings are estimated at 8.6 million dollars: 6.2 million dollars of warehouse labor, 2.1 million dollars of freight from fuller truckloads and 1.4 million dollars of avoided markdowns on aging stock, less 1.1 million dollars of added maintenance and software. The equipment is depreciated straight-line over eight years to zero, or 4.75 million dollars a year, and is expected to be sold for 3 million dollars at the end of year 8. Brightwater's tax rate is 24 percent. Daily replenishment is expected to reduce inventory by 10 million dollars in the first year, which is a cash inflow; conservatively, the analysis assumes that inventory returns to its prior level when the facility is retired, reversing the inflow in year 8. Financing costs are excluded from the cash flows because they are reflected in the discount rate.

Operating Cash Flow

Annual operating cash flow is after-tax operating income plus depreciation. Savings of 8.6 million dollars less depreciation of 4.75 million dollars give additional operating income of 3.85 million dollars; after 24 percent tax, that is about 2.93 million dollars. Adding back depreciation, which reduced taxes but used no cash, gives operating cash flow of about 7.68 million dollars a year. Equivalently, the after-tax savings of 6.54 million dollars plus the depreciation tax shield of 4.75 times 0.24, or 1.14 million dollars, produce the same result. The after-tax salvage value is 3 million dollars times 0.76, or 2.28 million dollars, since the equipment will be fully depreciated.

The Cash Flows

Table 1 shows the project's cash flows in millions of dollars.

Table 1

Incremental Cash Flows for the Automated Distribution Center, $ Millions

Note. Composite figures, rounded to two decimals. Parentheses indicate outflows.

Decision Measures

Discounting each year's net cash flow at 9.5 percent and subtracting the initial investment gives a net present value of about 9.1 million dollars. A positive net present value signals a return above the 9.5 percent its capital costs, adding about 9.1 million dollars to the value of the firm. At about 17.7 percent, the internal rate of return, meaning the rate that would bring net present value down to zero, sits well above the hurdle rate. Because the year 8 cash flow is slightly negative, the cash flows change sign twice, which can in principle produce more than one internal rate of return, but the final outflow is so small that the result is unaffected. The payback period is about 3.6 years, and the profitability index, which compares discounted future inflows with the upfront outlay, is about 1.24, meaning each dollar invested returns 1.24 dollars in present value. All four measures point the same way. Net present value is the primary measure, because it states the gain in dollars and discounts every cash flow at the correct rate; the others help communicate risk and liquidity (Dahlquist & Knight, 2022).

Sensitivity

The result depends on two assumptions: the savings estimate and the inventory reduction. Table 2 tests both.

Table 2

Sensitivity of the Distribution Center Decision

Note. Composite figures. All scenarios use a 9.5% discount rate.

Risks and Benefits Outside the Cash Flows

Several considerations do not fit neatly into the table but should shape the decision. The first is implementation risk. Automated warehouses often run below capacity for months after opening while software is tuned and staff learn new processes, and a slow start during the holiday season could leave stores short of stock when demand peaks. Scheduling the opening for early spring and running the old warehouse in parallel for several weeks would reduce that risk, at some extra cost. The second is technology risk: automation equipment may be outdated before eight years pass, which is one reason the analysis assumes only a modest salvage value. The third is the effect on employees. The labor savings come largely from fewer warehouse positions, and how the company handles that transition, through attrition, retraining for the new facility's technical roles or transfers to stores, will affect morale and its reputation in the community. Finally, the project has benefits not counted here. A daily-shipping network could also fill online orders from the same building, supporting Brightwater's fastest-growing sales channel, and that option has value even though it is not yet a firm plan. Taken together, these factors do not change the recommendation, but they argue for a careful launch plan and for treating the online option as an extra reason to invest, kept outside the base-case numbers.

Recommendation

Brightwater should fund the automated distribution center. The project earns a positive net present value in the base case and remains positive if either key assumption falls short, turning negative only if both fail together. Nearly half of the base-case value comes from the 10 million dollars of inventory the project frees, which also addresses the company's weakening liquidity. That makes the inventory reduction the condition for success: management should set a target for days of inventory in the stores served by the new center and track it monthly from the first quarter of operation. Survey evidence indicates that large companies lean on discounted cash flow tools in decisions like this one (Graham & Harvey, 2001), but the analysis is only as reliable as its assumptions, and the value here depends on changing how stores order, not only on installing machines.

References

Dahlquist, J., & Knight, R. (2022). Principles of finance. OpenStax. https://openstax.org/details/books/principles-finance

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

Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2022). Fundamentals of corporate finance (13th ed.). McGraw Hill.