In early January 2004, Twilight Acre Farms, a mid-sized, family-owned
farm, had just finished a season of harvesting its 4,000 acres of land. At the end of the season, Steve Twynstra, owner of Twilight Acre Farms, had to decide whether to purchase a new combine or perform significant repairs on the existing machine. He realized that the decision needed to be made before the next harvesting season, but he was unsure of which option would fit best for the company.


WHEAT, GRAINS AND BEAN FARMING IN ONTARIO1
In Canada, the family farming industry had seen better days. According to Statistics Canada, the number of farms in Canada dropped by 11 per cent to a total of 246,923 farms between 1996 and 2001. The rate of decline was even higher in Ontario at 11.5 per cent.2 Lower profit margins in the industry necessitated higher acreage, increasing the average farm size by 10 per cent. Although small farms still made up two-thirds of all farms in Canada, almost half of farms with less than $25,000 in total revenue counted in the 1996 census had left farming by 2001.3


The farming industry relied heavily on weather conditions and was deeply affected by fluctuations in world commodity pricing. This volatility particularly affected smaller farming operations. Farming industry products were commodities, so there was little room for differentiation. If all farmers produced a quality product, all produce would be sold; however, the price for all farmers could be lowered. If a clean, quality product was not produced, the farmer would receive a lower price.
There were, however, other forms of competition in the farming industry: competition between local
farmers for valuable, workable land to rent; competition for contracts with buyers; and competition for custom work (for example, combining crops of corn, soybeans or wheat, or cutting and baling fields ofhay).4 In most regions, the farming community was socially close-knit. Reputation and integrity were well-respected attributes.


TWILIGHT ACRE FARMS
Twilight Acre Farms Limited was a family-run farming operation, started in 1961 by Peter and Dini Twynstra. Despite taking over the farm in 1995 from his parents, Steve Twynstra had been directly involved in his parent's business since 1988. Before joining the family operation, he completed a bachelor's degree in agricultural economics at the University of Guelph and a masters in finance from Purdue University.
Twilight Acre Farms primarily planted, harvested and sold wheat, beans and corn. When there was excess capacity, Twilight Acres would take on custom work for other farmers in the community. Twilight Acres worked 4,000 acres of land each year, although it owned approximately only 1,200 acres. The rest of land was rented on long-term leases.


CURRENT ISSUE
At the end of the 2003 harvesting season, Twynstra noted that one of his two combines required significant repairs. He was unsure of whether to repair the existing machine or to replace it with a new machine. He felt that he should make the decision as soon as possible so that he would have the deal negotiated and closed well before next year's harvesting.


Existing Machine
Twynstra was using a CaseIH 2366 with a 25-foot grain head. He had bought the machine in 1999, and had just completed the payments for the machine. He estimated the existing machine required repairs of $27,000 immediately and $10,000 in the second year. In addition to the major repairs, Twynstra recognized that combines typically required about $4,000 per year of maintenance. He also felt that after another four years, the CaseIH 2366 would no longer be functional, and he would need to invest in new machinery at that time. After the four years, he assumed he would get $75,000 as a trade-in value.


New Machine
Twynstra was also considering buying a new CaseIH 2388. He planned to put the existing 25-foot grain head on the machine even though it did have the capability to support a 30-foot grain head.
The new machine's cost was $267,000, but the dealer offered a $152,000 trade-in value for the older machine. Twynstra would be forced to finance the rest of the purchase through a bank or through the Farm Credit Corporation. He had been offered a 5.9 per cent financing rate over a four-year term. The expected payments were $16,347 with two payments per year. At the end of the four years, Twynstra would own the machine.


The new machine offered approximately a 15 per cent productivity increase over the existing model. This would reduce the usage hours each year on the machine from 440 hours to 380. Twynstra felt that the productivity improvement could lead to a variety of savings, such as reduced labor, fuel and maintenance costs. He currently paid his workers $20 per hour, including benefits. Fuel costs per hour had been estimated at $22.96.5 The maintenance costs were expected to decrease yearly to $2,000, but for the first year and a half, the new machinery would be under warranty. Twynstra recognized that the new machinery would qualify for a capital cost allowance of 30 per cent per year. Twilight Acre Farms' tax rate was 21 per cent, and Twynstra expected that, in four years, the machine would have a trade-in of approximately $140,000.


Twynstra also felt there were some intangible benefits to owning the new equipment. His workers took pride in using new equipment and would potentially perform better.


In addition, he recognized that
Twilight Acres rented a large percentage of land, and he felt new equipment affected the landlord's opinion of the operation. Twynstra also recognized that some years the harvest could be so great that the increased capacity could be required. He could not estimate the actual benefits but recognized that during these years, the extra capacity was worth approximately $35 per acre,6 depending on the crop. He knew that the custom work could be minimal but wondered how many hours he would need to justify the investment.


Despite the intangible upsides, Twynstra was concerned about increasing the level of debt in the business. Debt was becoming a major issue in many mid-sized farms, and he did not want to take on additional financing unless required. Also, Twynstra could not be certain about the improved performance as the new machinery offered few technological improvements. Finally, he wondered whether he could get a 15 per cent return on his investment into the machine.


FINAL DECISION
Twynstra sat down and wondered whether or not he should buy the new CaseIH combine. He realized that he would need to crunch some numbers in order to be sure, although he knew the numbers were only part of the story. He hoped to make the decision in the next few days.


Omit the Canadian 30% capital cost allowance and instead, assume the following:
The current combine has been fully depreciated to a $0 book value
The new combine will be depreciated using 3-year MACRs rates of 33%, 45%, 15%, and 7%.


Questions to consider:
Preform an NPV analysis for the capital investment decision
How would custom work influence your decision?
What are the qualitative pros and cons of purchasing the new combine?
What would your decision be?

Answer rating: 100% (QA)

Answer The Net present value of cost involved in repairing the existing equipment 116017 The New pre... View the full answer