Plumco Fittings Corporation

Capital Investment – Risk Analysis

Plumco Fittings is a southwest manufacturer of piping, tubing and assorted flanges for the industrial and home plumbing industry. In 1983 the company started out as a                      manufacturer of specialty piping and tubing for the refrigeration industry.  The company  grew slowly initially as they developed a larger customer base and a strong customer        relationship with careful detail to their distribution and service network.

Rapid growth in sales and products took place in the 1990s through the late 2000s as the  company developed some new fittings and flanges for customers and acquired many        other firms in similar activities.  The continued growth in the southwest has been a mixed blessing for Plumco as there has been slow but continued growth in the plumbing needs   business.  The area of growth has been in home plumbing needs, representing the smaller portion of Plumco’s business, which has become very competitive as other producers       have set up their own distribution networks. Due to the competition and the lower growth in their traditional businesses Plumco has decided to investigate other business                 opportunities.

John Simpson, the treasurer, was mulling over the preliminary data on two investment     opportunities available to the firm. As a member of the management executive committee he has to decide whether to recommend any project(s), if at all. Before he sends the          summary data to the other executive committee members he plans to determine how such projects would fit in with the current investments of the firm. The level of business of the past twenty five years or so has grown to an expected $341,780,000 for this fiscal year     with modest of 3% per annum growth expected for the foreseeable future. The net profit  margin has been about 8.2% for the past few years and is expected to continue due to       their proprietary advantage on many of their specialized industrial fittings.

Mr. Simpson, being the treasurer, is the first executive the president and chairman of the  board turn to when stockholders are disgruntled about the poor performance of the           investment in Plumco. The past few years have been evidenced by a slower rate of price  appreciation. Since the firm has only paid a nominal dividend with the yield varying from .5 to about 1.5% the investors are very much concerned with their price appreciation. The common stock price of Plumco has been fairly steady and has risen slowly over the past   few years within an increasing stock market.

The return on the stock market has been on average about 20% greater than the return on Plumco's stock given the movement in their respective returns.

Bob Bailey, a new financial analyst with Plumco, brings in third quarter financial report for Mr. Simpson's approval while he is looking over the investment data. Mr. Simpson  realizing that greater analysis of the two projects is necessary, based on the data he has

This case is for academic learning purposes only.  @Copyright 2022, D.A. Burnie

and the apparent stockholder concern over slower price appreciation, has decided to have Bob continue the analysis.

"Mr. Simpson, the third quarter reports are done and here for your approval," said Bob    Bailey as he handed them to Mr. Simpson. "Excellent, … , excellent work, Bob" said Mr. Simpson pausing for a moment, "we have another project that I think you will find more interesting. We have two investment opportunities available to us from which we have to decide if we should invest or not.  Don't be concerned with the capital as we could           probably raise enough for both if need be."

Mr. Simpson next hands Bob the file of data that was given to him by the marketing and  production people on sales and costs, etc. He also explains to Bob the concern of the        shareholders over the apparent slow appreciation but thought this might just be an            overreaction as the market seemed so hot and everybody wanted in on the action. The      stock of Plumco never was a high flyer or much higher risk investment than the market in the fifteen or so years of public trading. The early years were more volatile until growth   had slowed somewhat and became consistent. Mr. Simpson was concerned that if they     put too much emphasis on greater price appreciation they would be taking too great a risk and that many of the current stockholders would be unhappy and decide to sell which       would possibly increase the volatility of the stock.

Bob Bailey went back to his office with file and began to look over the contents. After    Mr. Simpson's concerns he was a little surprised to find that the two investment               opportunities tied in so well with the current lines of business. Both could use the current distribution and sales network to a large extent, although the plans did call for more         salespeople and increases in the size of their distribution facilities. Besides investing in   additional assets, other costs would arise due to the additional administrative tasks and    handling of accounts.

The investment in the sheet metal rolling business seemed a natural for Plumco since they would manufacture heating and air conditioning duct pipe, fittings and vents. Total           expected sales are $75,000,000 per year. Bob thought this was high but the marketing       report notes that there is only a small replacement market and that much of the sheet         metal work is done for a specific job or on the job site. The electrical wiring, fitting and    fixture investment requires a bigger investment of $100,000,000 compared to only            $30,000,000 for the metal rolling, as it is a new line of business. The expected sales are    twice as great at $150,000,000 per year. The range of sales is much greater for the             electrical investment causing some initial concern about the added risk in Bob's mind.      The sales for both are expected to grow at 3% for the first 7 years, 1% for the next four     years and then flatten out. The working capital requirements of the two investments vary  as well.  The rolling business will require an additional 12% of sales while the electrical   will be 15% of sales.

Before Bob goes on any further in the analysis he has decided to gather some more        information about his company. He notes that the current yield on corporate bonds for a firm like Plumco is 9%.

The company traditionally has charged off depreciation on a straight line basis and          expects to in the future. Current depreciation is $10,500,000 due to the age and price       composition of assets on the books. The two investment opportunities had expected lives of fifteen years each at which time the assets are expected to be worthless and need to be replaced if they continue in that line of business.  The variance of the net income             calculated by Bob Bailey is $47,238,129 assuming that the distribution is normal for all  the data.

Other data Bob has collected is:

Plumco Total Assets = $227,350,000

75%

74%

Materials are about 40% of the total cost of goods sold, labor is 40% and overhead expenses make up the remaining 20%.

Increase in Selling and Administrative Expense

- Sheet Metal

- Electrical

Tax Rate (federal plus state)

5%

9%

26%

In addition to determining the standard value of the projects, the treasurer's staff

was to subject the individual capital expenditure proposals (projects) to additional

analysis and scrutiny. The purpose was to ensure that the risk and return prospects each

proposal were understood.

Bob Bailey believed there were several issues needed to be addressed, none, in

his view, was as critical as a sensitivity analysis . He felt the proper "what if” questions

must be asked for each expenditure. While sensitivity analysis was a standard practice on

cash inflows but Bailey believed that its use must be broadened and thus made to

correspond more closely with the company's operating characteristics .

The company in recent years had dealt with a much more geographically diverse

group of suppliers and an increasing amount of the company's raw materials experienced

greater market driven price changes . As a result of this new environment, prices and

supplies would occasionally change without much advance notice. Therefore, Bailey

wanted to place the emphasis of sensitivity analysis both on the "cost " side as well as the

cash inflow side of capital budgeting analysis .

In effect, those projects would be subject to an analysis based upon additional

information concerning the following factors : cost increases/decreases for the various

raw materials, labor components and cash inflows . The projects because of being in the

broad business realm of Plumco were deemed to be of the same risk as the average

project within the firm ; therefore, they are each to be evaluated at the firm's cost of

capital,  12 percent . The expenditures for each of the projects are to be made in the year

before the cash inflows were received.

Bob is concerned about the impact of various factors given the evidence he has

collected from the last  10 years of projects . The use of sensitivity analysis will enable the

analysts to obtain clearer information concerning the return on projects . That is, the

additional analysis will allow a more realistic assessment of risk and return.

1.  The project costs may vary by up to 10 percent versus the original.

2.  About  10% of the time the estimates for cash inflows for the project have been

overestimated.  The cash flows reached 90 percent of expectations in Year  1; 80

percent in Year 2; and 85 percent in Year 3 before levelling out and returning to a normal