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Is it convenient for Company X to invest in a new boiler?

Por: Alejandro Blaquier

Supervisor: Silvia Criado


Asignatura: Business
ABSTRACT

This work consists on the evaluation of the profitability of the buying of the new
boiler for Company X and what will be the benefits for Firm X when buying the new boiler.
Company X is located in Jujuy, the north of Argentina.

To be able to get the best investigation possible I used a SWOT analysis, investment
appraisal and ratio analysis. The results from the SWOT analysis were very positive, as well
as the ratio analysis. On the other hand, the investment appraisal has a good result in the
average rate of return but, a very long payback period of 11 years.

Evaluating all the data collected I can say that it will be convenient for Company X to
buy the new boiler because it will mean lower consumption of gas, less dependence on the
national net of gas, assure continuous production by avoiding the cuts in the provision of gas
and the availability to sell the CO2 emission bonds to other companies and make a profit to
pay the investment of the new boiler.

To conclude, I will recommend Company X to invest in the new boiler because it will
have great consequences for the development and growth of the firm. Although the
investment will have a high cost but, the money saved by the new boiler will be much higher
than the initial cost of investment.
INTRODUCTION

This work will consist on the evaluation if it is a good decision to buy the new boiler
and therefore, reduce the consumption of gas when producing electrical energy. This
investigation will consist on the following tools to be able to get the best evaluation of the
decision: SWOT Analysis, Investment Appraisal, Profitability Ratios, Liquidity Ratios and
Efficiency Ratios. This tools will allow me to have a wider and deeper analysis of the
decision and therefore to make my choice the best possible.

Firm X is an Argentine company that it is situated in Jujuy, the north of Argentina.


The firm was created in 1830 and in 1908 the name was changed to the present one. Firm X
directly employees 5,989 workers. Company X produces 377,022 tons of sugar per year,
33,053 kiloliters of alcohol per year, 109,361 tons of paper per year, 45,309 tons of packaged
fruits per year, 6,216 tons of juice per year, 2,505 tons of meat per year and 165,183 tons of
cereals per year. Company X is the leader of production in the sugar market with a 22% of
the market share.

The question consists on the decision whether to or not to invest in the new boiler and
what effects will have this on the production of Company X. This decision will be evaluated
in different ways so that it will be able to show and recommend the best option for Company
X.

This decision is important because it will mean a decrease in the consumption of gas.
In the context of the company the gas consumption is very important because there is a
limited provision of gas in Argentina 1 and this has a severe consequence of the production,
because during winter Company X suffers cuts in the provision of gas 2. These cuts in the
provision of gas will mean a stop in the production for more than one day and at the end of
the production season it will mean a decrease in the production of Company X making them
loose customers and eventually money. These cuts in the provision of gas are more frequent
in winter because the government prioritizes the provision to homes rather than to businesses,
and in the homes people turn on the heating system 3. Also, the decision is important because
1
Argentina vuelve a recortar provisin de gas a causa de bajas temperaturas, en El Economista (en lnea),
<http://www.eleconomista.net/noticia.php?id=834> [consulta: 7 agosto 2009]
2
OLIVERA, F., Cortes de gas a ms de 140 empresas, en La Nacin (en lnea)
<http://www.lanacion.com.ar/nota.asp?nota_id=1150602> [consulta: 7 agosto 2009]
3
Flores, M. A., Con el frio volvieron los cortes de gas a las grandes industrias del pais, en Los Andes (en
lnea), <http://www.losandes.com.ar/notas/2009/7/15/economia-435263.asp>[consulta: 7 agosto 2009]
the new boiler is more efficient than the older ones so the consumption of gas will decrease
by a 25% that will mean fewer cuts in the provision of gas and therefore the production could
be maintained at a profitable amount.
CHAPERT 1
DATA COLLECTION

Firm x has a central in Jujuy that produces all the paper and the sugar. The factory
has the following plan of production:

The Sugar Factory has an input of approximately 4 million tons of sugar cane per
year. This same factory has three outputs, approximately 410,000 tons of sugar per year and
approximately 40,000,000 liters of hydrated alcohol per year. Both the alcohol and the sugar
are sold. Also, there is an output of approximately 1,210,000 tons of humid bagasse per year.
The humid bagasse has a 51% of water in its mixture. The bagasse divides in to two,
approximately 808,000 tons for the energy production and 432,000 tons for the paper factory.
In the paper factory, there is an output of approximately 120,000 tons of paper per year, ready
to be sold. On the other hand, in the Energy production, there is an input of 180,000,000
cubic meters of gas per year. This factory is formed by three gas-burning boilers, 12 bagasse-
burning boilers and three turbines. This energy production will send gas and electrical energy
to the other two factories, the paper one and the sugar one.

This work will be based on the energy production factory because it depends on the
buying of the new boiler. The energy production factory consists of two gas-burning boilers
that will produce 150 tons of vapor/hour and one more gas-burning boiler that will produce
110 tons of vapor/h. Also, there are 12 bagasse-burning boilers. Ten are the oldest ones and
will produce 20 tons of vapor/h with an efficiency of 63%. Also there are two newer ones,
the first bagasse-boiler was bought in 1981 and produces 127 tons of vapor/h with an
efficiency of 85%. The second bagasse-burning boiler produces 140 tons of vapor/h with an
efficiency of 85%. The energy production factory also has 6 turbines. The oldest three,
produce 2.5 MW each one. On the other hand, the other three are more efficient, have a
greater capacity and are newer. The first one produces 16 MW, the second one 22 MW and
the third one 40 MW.

The new boiler, available to use with gas and bagasse, that will be bought costs 20
million US dollars. It will have an efficiency of 85% the same as the other ones. It will
produce 200 tons of vapor/h, much more than the other boilers. The objective of the new
boiler is to replace the ten old bagasse-burning boilers that all summed up have the same
production as the new one, but with the difference that the new one will need less gas to work
since it has a greater efficiency, 85% to 63%. The new boiler will decrease the consumption
of gas in a 25% because of its efficiency. The new boiler will have a life of half a century, 50
years. The difference from other investments is that this boiler would not generate more
money than the old ones, but it will make Company X save money when consuming gas,
because the total amount of gas needed
will be less than with the old boilers.

The new boiler that will be


bought is from Brazil, from HPB
Engenharia e Equipamentos Ltda. The
boiler costs 20 million us dollars and has
a capacity of pressurizing the vapor at
two different pressures, 65 ATA and 480
degrees Celsius or 45 ATA and 420
degrees Celsius. The different pressures of the vapor will be needed for each of the different
turbines, which will allow them to have a different output of electrical energy. The capacity
is 200 tons per hour when bagasse and gas are used as fuels. The efficiency at 45 ATA and
420 when using bagasee is of an 85.70%, and when the fuel is natural gas, the efficiency is
of 92.60%. On the other hand, when the desired pressure is 65 ATA and 480 the efficiency
will decrease and be 85% for bagasse and a 92.50% when using gas.
SWOT ANALISIS

To evaluate the decision I used a SWOT analysis so that the decision taken is the best
one. The SWOT analysis will consist on the strengths, the weaknesses, the opportunities and
the threats of the decision.

Strengths

The strengths of the decision are less dependence on external energy resources, lower
use of gas, lower costs of production and maintenance by the elimination of the old and less
efficient boilers and the availability to have electrical energy to sell to the network. With the
new boiler Company X will be able to have a lower dependence from the national network of
energy. This will allow the firm to have a more precise prediction of the total output and a
better forecast of the financial accounts of the company because they would be able to avoid
the cuts in the provision of gas. The cost of production will decrease because the old boilers
needed more maintenance than the new one and the replacements are difficult to find and
much more expensive. Also, as the new boiler is more efficient Company X will be able to
reduce the buying of gas and still produce more energy than with the old ones. The electrical
energy that it is not used will be sold to the network and therefore Firm X will earn more
money.

Weaknesses

The weaknesses are that the boiler would only be used during the time of the harvest,
so there will be a problem to save and store the bagasse. This will be a weakness because as
the boiler is more efficient the use of gas and bagasse will be lower and therefore there will
be more bagasse left to rot. The bagasse will be lost because of the impossibility to store it,
so production of paper will eventually decrease. Bagasse cant be stored because it will rot if
it is left in the open air; also, it is impossible to store it in a warehouse because it will be too
expensive to build one so that the bagasse can be stored. Moreover, another weakness is that
the new and more modern boiler will need a better and professional training and skills to
make it work. Therefore Company X has two options, or to train the existing workers or to
hire new ones that have the capacities to run the new boiler.

Opportunities

The opportunities of the decision are that it will contribute to decrease the
contamination of the environment, less emission of greenhouse-effect gases. This is an
opportunity for Firm X because it will be able to sell the CO2 emission bonds to other firms
and nowadays these bonds have a very high demand. On the other hand, less consumption of
natural gas will be an opportunity because in Argentina there is a shortage in the provision of
this fuel, the prices are rising and the government is making cuts of gas in winter so the
production has to stop some days, due to the impossibility to produce electrical energy. Also,
nowadays, the world is sympathizing with the environment and people are starting too aware
about what is happening with the Earth, so it will be considered a good image for rest of the
world if Company X is trying to preserve the environment. Then Firm X will be able to do
some advertising showing that they are environmentally friendly and that they are interested
in what is happening in the world, this will be an opportunity because the consumers in the
world are looking for more environmentally methods of production.

Threats

The threats of the decision consist on an increase in the price of fuels, gas and
petroleum. This will mean an increase in the cost of production but they will depend on
external factor such as the price imposed by the local government or by the international
price. Also, in Argentina there is a decrease in the production of gas cause by the concession
of the producers of gas being too short and making impossible a good investment or even a
maintained one in new technology for the extract of gas. This will cause that the producers of
gas would not invest in the exploration of new reserves of natural gas, and the supply of gas
will decrease while the demand for gas will increase. This will eventually cause shortcuts in
the production of gas because in winter the demand is much higher than in the rest of the year
so the supply of gas to firms is cut, prioritizing the use of gas for houses and families.
Moreover, Argentina has a problem of political instability that will cause firms to have
problems in their production. For example, the government would not ensure provision of
gas to factories, although the government is in charge of the firm that provides gas to the
whole country. In addition, these political instabilities will bring economical problems to the
country when trying to predict sales or other economical statistics like inflation.

To sum up, the SWOT analysis helped me to see the strengths, the weaknesses, the
opportunities and the threats of buying the new boiler. The overall result of this analysis is
that the strengths are stronger then the weaknesses and that the opportunities are better than
the threats. In this case you can see how the decision would bring good consequences to
Company X, by making it less dependent on the national net of natural gas, decreasing the
consumption of natural gas, let the factory be more environmentally friendly and therefore,
be able to sell CO2 emission bonds to other companies. With this analysis I can say that it is
convenient for Company X to buy the new boiler and replace the old ones.

INVESTMENT APPRAISAL

To be able to measure the profitability of the new boiler I uses an Investment


Appraisal method to see in how much time will the boiler payback its initial investment, also,
I will calculate the total profit after paying the investment compared to the initial cost of
investment of the new boiler, by using the Average Rate of Return method.

In the first place, to calculate the Payback method of the new boiler, instead of
calculating the money generated I calculated the money saved in paying for the use of gas.
One of the problems of this method is that it does not measure the overall profitability of the
project; it would not calculate the money spent in the installation of the boiler, the money
spent in routine maintenance and the replacements of parts that may break when used. To be
able to do this I had a meeting with an engineer in the firm, and he was able to give me all the
data and the values for the gas consumption. Firstly he told me that the hour consumption of
natural gas is 1273 and the new boiler would save a 25% from the total consumption,
therefore I calculated the total natural gas saved in a day. Then I multiplied this value by the
price of a in Argentina and got the amount of money saved every day with the new boiler.
Then to calculate the Payback I divided the initial cost of investment (20000000$) by the
money saved per day. The total payback will be in 11 years and 18 days. This is not a good
payback because it will take too long and if Company X receives the finance externally they
will have to pay interests when repaying or if the finance is obtained internally the money
invested will have an opportunity cost. Also if the payback is too long the final result will not
be so precise because the price of one of natural gas can change and therefore the
payback time may change. As well, in so much time there is an uncertainty with the
development of the country, you are not able to predict what will happen.

In the second place, to calculate the Average Rate of Return I used the life of the new
boiler (50 years) and the money saved with the new boiler in one year (1.81 millions) and the
initial cost of investment (20 millions). To the total life of the boiler I subtracted the years
that it took in the payback, then I multiplied the amount of years by the money saved by year
and then I multiplied it by 100 to get the value in a percentage. The Average Rate of Return
is 325.86%. This is a very good result because it will imply that during the total life of the
new boiler the profit done by Company X will be approximately 65 millions.

To round up, the investment in the boiler had a negative and a positive aspect. The
negative one is that the payback time is too long and that as show before the payback method
will lose its accuracy because in 11 years the price for natural gas will change, and also
Company X will have to pay high interest rates in order to repay the loan. On the other hand,
the positive aspect is that the new boiler will have a high Average Rate of Return (325%), and
this will allow Company X to have more money to adjust any inaccuracy with the payback

method. Also, the money could be used to pay the additional costs that the functioning of the
boiler would imply.
CHAPTER 2
DATA ANALYSIS

RATIOS

I decided to use a ratio analysis to find out how the investment of the new boiler will
affect Company X and if the firm is prepared to invest such money. Also, these ratios will
allow me to identify how the performance of Company X is. To make the analysis I used
profitability ratios, liquidity ratios and efficiency ratios. In the case of the profitability ratios,
I used gross profit ratio, net profit ratio and the return on capital employed ratio.
Furthermore, the liquidity ratios I used are current ratio and acid test ratio. Moreover, the
efficiency ratio I used was the gearing ratio.

In the first place, the profitability ratios are used to assess how is the companys
performance, focused on the management of a business. Firstly, I used the Gross Profit
Ratio, that for year 2008 the result was 34% and for 2007 it was 32.5%. In this case you can
see a slightly increase of about 1.5%. Secondly, the Net Profit Ratio had a small decrease in
2008. In 2007 it was 18.8% and in 2008 it is 18%. This decrease is very small, 0.8%, and it
will not have a big impact of the performance of Company X. Thirdly, the Return on Capital
Employed Ratio also decreases from 23.8% in 2007 to 22.25% in 2008. It decreased 1.55%,
which is not a great value. In the case of the Performance ratios we can see that the values
did not change in a great way since 2007, this means that Company X is passing through a
good performance moment.

In the second place, the liquidity ratios are used to show the availability of Company
X to pay short-term debts, and to see if the company is too liquid or if it should invest.
Firstly, the current ratio in 2007 was 2.5 and it decreased to 2.2 in 2008, this means that
Company X invested more money than in 2007 because it is better to invest the money rather
to have it tied up. Secondly, the acid test ratio in 2007 was 2.4 and in 2008 it decreased to
2.1. This case is similar to the one of the current ratio because it still shows that the money
has been invested. Furthermore, in both ratios you can see that the result are too high which
implies that Company X is able to pay its short-term debts and more, moreover, the ratio also
shows that there is spare money that could be invested to get a higher profit.

In the third place, the efficiency ratio will show the capacity of Company X to pay its
long-term debts, and the higher the percentage of gearing, the higher the risk. The result of
the gearing ratio for Company X is very good, a 4.3% in 2007 and only a 2.5% in 2008. This
shows that Company X has a very low gearing percentage, which implies that the y could
easily ask for a loan and pay it, having a low risk. This could be considered an advantage
because Firm X would be able to ask for a loan to pay for the new boiler and do not have any
problem with paying it.

To round up, the global performance of Company X is in a good moment, especially


the liquidity and the efficiency ratios. In the case of the liquidity ratio they can be improved,
moreover, the efficiency ratios are in a perfect state to ask for a loan to finance the buying if
the new boiler.

CONCLUSIONS AND RECOMENDATIONS


To conclude, after analyzing all the tools, I recommend Company X to invest in the
new boiler, because it will bring lots of benefits and good consequences to the firm.

The new boiler would spend less money when paying for the gas consumed because it
consumes less than the older ones. The investment in the new boiler would mean a great
change in a positive way for Company X. The firm will be less dependence from the national
net of natural gas, so that they can avoid the cut in the provision of gas. With the new boiler,
Company X will become more environmentally friendly, and therefore be able to sell the
CO2 emission bonds to other firm who need them. The new boiler is more efficient, so the
production of electrical energy will spend less money than what they usually do.

The investment appraisal has a long payback period that means that the initial
investment will be paid in 11 years. The investment has a very good Average Rate of Return,
giving much more money to the firm than the initial cost of investment. That will be able to
cover the long payback, and any additional cost of maintenance from the new boiler.

Company X has a great gearing ratio, which will allow them to ask for money, at a
low risk, so this will mean a lower interest rate. In addition, it has great liquidity which means
that Company X is able to invest in the new boiler. On the other hand, the profitability ratios
decreased from 2007 to 2008. This means that the firm has high cost of goods sold because
the gross profit ratio is around 34%.

To round up, I will recommend Company X to invest in the new boiler, because it lots
of good consequences and benefits for the growth and development of the firm.
BIBLIOGRAPHY

Sitios de Internet

Debtor Collection Period, Wikipedia:


<http://en.wikipedia.org/wiki/Debtor_collection_period>

Rate of Return, Wikipedia: <http://en.wikipedia.org/wiki/Rate_of_return>

Debtors Days, Wikipedia: <http://en.wikipedia.org/wiki/Debtor_days>

Payback Period, Wikipedia: <http://en.wikipedia.org/wiki/Payback_period>

Investment Appraisal, Time web.


<http://www.bized.co.uk/timeweb/reference/using_experiments.htm>

Investment Appraisal - Lesson Plan, Time web, <http://www.bized.co.uk/educators/16-


19/business/accounting/lesson/investment1.htm>

Gross Profit Margin, Biz/ed. <http://www.bized.co.uk/compfact/ratios/profit3.htm >

Investment Appraisal, The Times 100, <http://www.thetimes100.co.uk/theory/theory--


investment-appraisal--380.php >

Company Xs web page, that for a reason of confidentiality I prefer to have it anonymous.

STIMPSON, P., Business Studies, AS Level and A Level, Cambridge: 8th Edition,
University of Cambridge and International Examinations, 2008.