Capital Budgeting With Uptime and Covenant Constraints
A regional bakery considers a $2.4 million automated line. Expected annual operating cash savings are $520,000 for six years; salvage value is $150,000. The company's WACC is 11%, and the project's risk is similar to the firm's. The CFO computed an NPV of $187,000 and an IRR of 14.2%. The operations director wants approval. The controller notes the savings assume 92% uptime, but comparable equipment at a sister plant averaged 84% in year one, rising to 90% by year three. Working capital of $200,000 is needed and recovered at the end. A debt covenant limits annual capital expenditure to $3 million; another approved project already uses $900,000.
1. Adjust the NPV for working capital and realistic uptime. Is the project still clearly acceptable?
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The stated NPV appears to exclude working capital. The $200,000 is invested at time zero and recovered at year six, so its net present cost is $200,000 - $200,000/(1.11)^6 = $200,000 - $106,900 = about $93,100.
Adjusting savings for the sister plant's ramp: year 1 at 84% gives $520,000 x 84/92 = $474,800; year 2 at 87% gives $491,700; year 3 at 90% gives $508,700; years 4-6 remain $520,000. The present value shortfall versus the 92% assumption is approximately $40,700 + $23,000 + $8,300 = $72,000.
Adjusted NPV is roughly $187,000 - $93,100 - $72,000 = about $22,000. The project is marginally positive, not clearly acceptable. A small cost overrun or slower ramp erases the margin, so approval should be conditional on validated uptime assumptions.
2. How should the covenant and qualitative factors affect the decision?
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The covenant permits $3 million of annual capex, and $900,000 is already committed, leaving $2.1 million. The $2.4 million project exceeds the remaining capacity by $300,000. Options are to defer or phase the project, seek a covenant waiver, or renegotiate timing with the lender. Approving without addressing the covenant creates a compliance risk that outweighs a marginal NPV.
Qualitative factors include labor displacement and retraining, maintenance skills, supplier support and parts availability, customer service during installation, and strategic capacity for future growth. The controller should also ask whether the sister plant's 84% first-year experience reflects a different product mix or operator skill. If the project is strategically necessary, management should present a staged approval with a pilot and explicit uptime gate.
3. What sensitivity or scenario analysis should be presented to the board?
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Present a table showing NPV under combined scenarios rather than one-at-a-time changes:
- Base case and sister-plant ramp.
- Savings 10% lower and 10% higher.
- Uptime 80%, 86%, and 92%.
- Capital cost overrun of 10% and a six-month delay.
- Salvage value of zero.
- Working capital 50% higher.
Also show the break-even annual savings and the break-even uptime. Because the adjusted NPV is only about $22,000, the board should see how little cushion exists. Recommend a stage-gate: approve engineering and a pilot, release full funding only after measured uptime reaches an agreed threshold, and confirm covenant capacity before commitment.