Reference no: EM13111654

In 2002, Component Technologies, Inc. (CTI)I. manufactured components, such as interconnect components, electronic connectors, fiber-optic connectors, flexible interconnects, coaxial cable, cable assemblies, and interconnect systems, used in computers and other electronic equipment. CTI's global marketing strategy produced significant growth; CTI was now one of three major suppliers in its market segments. Major customers included other global companies, such as illM, HP, Hitachi, and Siemens. These companies, in turn, manufactured and marketed their products worldwide.

FlexConnex, one of CTI's largest selling products, was very profitable (see Exhibit 1). The Santa Clara, California plant that manufactured the FlexConnex component was projected to reach its full capacity of 75 million units in 2003. With sufficient capacity to meet demand, CTTexpected its sales of FlexConnex could continue to increase 10 percent per year as applications of computer technology extended into industrial products and consumer products such as automobiles and appliances.

PLANNING MEETING
At a meeting of his staff, Tom Richards, director of manufacturing planning, stated that they needed to plan to bring
additional capacity for FlexConnex online in about two years. He suggested that they begin by proposing possible
alternatives.Thestaffquicklyidentifiedthreepromisingalternatives: .

1. The Santa Clara plant had been designed for future expansion. Additional space was available at the site, and
new production capacity could be easily integrated into the existing production processes as long as compatible
manufacturingtechnologieswereemployed. .

2. CTI owned a plant in Waltham, Massachusetts that manufactured a product line that was being phased out.
Some existing equipment in the Waltham plant was compatible with the Santa Clara plant's manufacturing
technology and could be converted to the production of FlexConnex. Half of the Waltham plant would be
available in 2003, and the remainder in 2005.

3. CTI could build a greenfield plantZin Ireland, close to its ~jor European customers. To attract such industries,
the Irish government would make a site available at low cost. A new technology currently being Beta-tested3 by
an equipment manufacturer could be used to equip this plant.
Torn believed that these three were promising proposals. To ensure cn could bring additional, profitable,
FlexConnex capacity online in two years, Tom felt that they should begin developing plans for these alternatives.
Nonetheless, he wanted the staff to keep an open mind to additional altematives even as they evaluated these three.
As the discussion started to wind down, Gracie Stanton, an engineer, said that she had a suggestion.
Gracie: Before we spend our time developing these three alternatives in detail, I'd like to get a rough feel for the
potential profitability of each alternative. We should11'twaste our time developing detailed plans for an alternative if
there is no chance it will ever show a positive NPV.
Source: Issues in Accounting Education, by Julie H. Hertenstein, May 2000, Vol. 15 Issue 2, p. 257-261

I Thiscaseis basedondecisionsfacedby anactualcompany.ComponentTechnologies,Inc.,is a disguisedname.
Other facts bave been changed for instructional purposes.

2The term "greenfield plant" is commonly used to refer to a brand new plant built entirely.from scratch, as
contrasted with the expansion, conversion, refurbishment, or renovation of an existing plant.
3A "Beta-test site" refers to equipment being tested using an actual workload at a customer site. Beta-test is often
the final testing phase before the equipment is released as commercially available to customers.A customer who
consents to be a Beta-test site agrees not only to use equipment that is not fully tested (thus being, in the American
vernacular, a "guinea pig"), but also to provide the vendor detailed feedback on operations and problems
encountered. In return, the equipment manufacturer often provides incentives such as financial discounts, extra
on-site vendor personnel, etc.
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Tom: Good point, Gracie. Let's break up into three groups, and do back-of-the-envelope calculations based on what
we currently know about each alternative. Gracie, would you.head up the Santa Clara group, since you were part of
the engineering team for that plant? Edward Lodge, how about Waltham? Ian Townsley, could you and your folks
take a look at Ireland? To start, what are the facts and assumptions about each facility?
Gracie: Well, there's enough space at the Santa Clara site to produce an additional 30 million units annually. I
expect it would cost about $23 million to expand this plant, and bring its total capacity to 105 million units. Of the
$23 million, we would spend $5 million to expand the building, and $18 million for additional equipment
compatible with Santa Clara's existing manufacturing process. All $23 million would probably be spent in 2003, and
the plant would be ready for production in 2004.

I assume that the selling price per unit will remain at its current level; further, since the same manufacturing
technology will continue to be used, the variable manufacturing cost will remain the same as we show on the 2002
Santa Clara Cost Analysis Sheet [Exhibit 1]. Expanding the existing plant would allow some fixed manufacturing
costs, like the plant manager's salary, to be shared with the existing facility, so I estimate that the additional fixed
manufacturing costs, excluding depreciation, will be $2.1 million annually beginning in 2004. In 2006, these fixed
costs will rise to $2.4 million and remain at that level for the foreseeable future.
Edward: Well, the Waltham plant is smaller than the space available in Santa Clara, so I think its capacity will be
about 25 million units. It will require renovations to adapt the plant to manufacture FlexConnex, say, about $2
million, and approximately $12 million for equipment. Half of this would be spent in 2003, and half in 2005. Initial
production would begin in 2004; half of the 25-million-unit capacity should be available in 2004; two-thirds in
2005; the remainder in 2006.

Since the Waltham plant will use the same technology as Santa Clara, we can assume that the variable
manufacturing costs will be the same as Santa Clara's. Selling prices will also be the same. However, since Waltham
will be a stand-alone faculty, its fixed manufacturing costs, excluding depreciation, would be somewhat higher: $2.4
million annually beginning in 2004. In 2006, however, fixed costs will increase to $2.6 million annually, where I
expectthemto remainfor the foreseeablefuture. .
Ian: I just visited the Beta-test site for the manufacturing equipment using the new technology that I'propose we use
for the greenfield plant. There I learned that the economic size for a plant using this technology to manufacture a
product such as FlexConnex is about 70 million units, so I propose that we prepare our estimates for Ireland based
on a 70-million-unit capacity plant. Of course, this will cost more, since it is much larger than other sites. With the
help of the Irish government, an appropriate site can be obtained for about $1 million. A building large enough to
produce 70 million units can probably be built for about $10 million, and equipping the facility with the new
technology equipment wilt' cost about $50 million. Most of this would be spent in 2003, although as much as 10
percent might be spent before the end of 2002 to acquire and prepare the site. The plant would begin production in
2004; some areas of the plant would not be complete, however, and as much as 20-25 percent of the investment
would remain to be spent during 2004.
Although FlexConnex's worldwide selling price will be the same as for the other facilities, the new equipment will
lower the variable manufacturing cost to $0.195 per unit. The efficiency of this new plant will help keep fIxed
manufacturing costs down, as well, but since the facility will be so large, fixed manufacturing costs, excluding
depreciation, would be higher than the other two facilities: $2.8 million annually beginning in 2004, rising to $2.9
millionannuallybeginningin 2008. .
Tom: These assumptions sound like reasonable first cuts to me. Let's just start with a five-year analysis, 2003
through 2007, using the discount rate of 20 percent, which the corporate finance manual states is the hurdle rate for
capital investments. For simplicity, let's assume all cash flows occur at the end of the respective year. Discount
everything to today's dollars, that is, as of the end of 2002. And, consistent with corporate policy, we'll do a pretax
analysis; we'll ask the corporate finance staff to evaluate .the tax implications later.
A few minutes later, the buzzing of the small groups died down, and the tapping on the laptop keyboards had ceased.
Tom: Well, what have you learned from this first glance?
20-10

Edward: The Waltham site looks promising.
Ian: Not Ireland.
Gracie: This is odd. The Santa Clara plant is right on the margin, and that surprises me since the existing
manufacturing facility is one of CTI's most profitable, and we get further economies of scale by expanding that
plant. 1wonder if the discount rate we are using is too high. At the "Finance for Manufacturing Engineers" seminar I
attended recently, we discussed the problems associated with using a discount rate that was too high. The professor
stated that there was a sound theoretical basis for using a discount rate that approximated the company's cost of
capital, but many companies "added on" estimates for risk, corporate charges, and other factors that were less well
grounded. Based on what I learned in that seminar, I tried to estimate CTI's actual cost of capital; it was about 10
percent.l wonder what would happen if we used 10 percent instead?
Tom: With these laptops and spreadsheet programs, that's easy enough; let's check it out.
A few seconds later, . . .

Gracie: Now, that's better!
Edward: Ours too.
Ian: Well, at least we're moving in the right direction. But it doesn't make sense to me that a facility with lower
variable cost per unit, and lower average fixed cost per unit at capacity, shows a negative NPV when the others are
positive. We checked our calculations; what's the story? Could it be that Ireland would not even be up to capacity
production in five years because the plant is so big?
Gracie: Maybe, but our plants are being penalized, too; after all, even though they reach capacity in the first five
years, they will presumably continue to produce FlexCoDl1ex.Although there is constant technological change in
this industry, there is a reasonable probability that demand for FlexCoDl1exwill remain strong for at least 10 years.
Ian: Well, then, let's look at each of the three plants over a ten-year period, using Gracie's 10 percent discount rate.
Later.. . . .
Edward: Aha! Waltham continues to improve.
Gracie: However, Santa Clara has you beat now!
Ian: I've got bad news for both of you!

QUESTIONS:
1. Prepare the manufacturing staffs calculations for the three alternatives:
a. In the fIrst set of calculations, the staff used a discount rate of 20 percent, a fIve-year time horizon, and
ignored taxes and terminal value. What is the relative attractiveness of these three alternatives?
b. In the second set, they used a 10 percent discount rate. What happens to the NPV of each alternative? What
happens to their relative attractiveness? Why? .
c. In the third set, they changed the time horizon to ten years, but kept the 10 percent discount rate. Why does
Ian say he has "bad news" for the others?

2. In addition to reducing costs, the new technology proposed for the greenfield plant would increase
rnanufacturing flexibility, which would enable eTI to respond more quickly to customers and to provide them
more custom features. Should these factors be considered in the analysis? If so, how would you incorporate
them?

3. Should other factors be taken into consideration in choosing the location of the FlexCoDl1explant? If so, what
are they?

4. Should Torn Richards continue to develop more detailed plans for these.three alternatives? Hnot, which should
be eliminate a? AIe there other alternatives that his staff should consider? If so, what are they?
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EXHIBIT 1 FlexConnex Cost Analysis Sheet
Santa Clara Plant, 2002
Plant Capacity: 75 million units
Selling PricelUnit: $0.85
Variable CostlUnit: $0.255
Fixed Manufacturing Cost: $9.5 million annually (included $2.5 million depreciation)
Estimated Plant Profitability at Capacity:
Revenue $63,750,000
Variable Cost <19,125,000>
Fixed Manufacturing Cost* <9,500,000>
Plant Profitability $35,125,000
*Excludes interest expenses and corporate selling, general and administrative expenses