Fab Laundry Products Company's Results - Case Study Example

Case Study About the Fab Laundry Products Company Name: Course: Tutor: Date: 1. Critical analysis of the cost of the two proposals over the period of 5 years will enable one to identify the less costly company on which the equipments and facilities should be purchased. This can be well analyzed in table one. Table 1: Analysis of the cost of purchase over 10 years Cost Donnalley Doyle Initial cost 2,000,000 1,200,000 Shipping fee 0 10,000 Installation fee 0 20,000 Total cost 2,000,000 1,230,000 Total cost after 10 years 2,000,000 2,460,000 Less salvage value after 10 years 100,000 100,000 Net cost of purchase 1,900,000 2,300,000 NPV Cost PVIF (12%) Donnalley NPV Doyle NPV Initial cost 1 2,000,000 2,000,000 1,230,000 1,230,000 Cost after five years 0.567 1,230,000 697,410 Total cost 2,000,000 2,000,000 2,460,000 1,927,410 Salvage value (5 years ) 0.567 (50,000) (28,350) Salavage value (10 years) 0.322 (100,000) (32,200) (50,000) (16,100) Total cost 1,900,000 1,967,800 2,300,000 1,882,960 Analysis It is evident that though purchasing equipments and facilities in Donnalley appear to be cheaper, they are the most expensive in ten years time. This proved by the fact that the company will incur a net cost of AUSD 1,967,800 for purchasing the equipments and facilities in Donnalley Limited while by purchasing the equipments and facilities in Doyle the company will incur AUSD 1,882,960 within a period of time. The total cost for 10 years on purchase of the equipments in Doyle was computed by multiplying its cost for five years by 2 (AUSD 1,230,000*2). This was an assumption that the company will have to purchase new equipments and facilities from Doyle after five years again since the original facilities are expected to be useful for only five years. Another assumption made was that both companies are in a position to supply the equipments on similar terms indefinitely. Contrary to chief financial officer, purchase of equipments in Doyle will be cheaper for the company in the long-run, thus it will be prudent to purchase the equipment from Doyle Limited Company (Brigham 112). 2. While carrying out a capital budgeting, all cost which is brought by the new project is supposed to be accounted for as cost of the new project. In this regard, the cost from marketing testing concerning the new project line is a specific cost for the new project thus it should be included as initial cost of the new project. According to the matching principle of generally accepted accounting principle, the expenses must be matched with their respective revenues. Thus cost incurred due to marketing testing of the new product must be matched with the revenue generated from the new product in order to determine its actual profitability. Cost incurred within an organization is always a cash outflow thus cost of marketing testing is one of the aspects of cash outflow of the company incurred due to the introduction of the new product (Brigham 64). 3. Cash flow of a new project should be any cash flow changes brought about by the new project. In other words, a company must assign cost to their respective projects or products for better financial analysis to be carried out. In this regard, the interest on loan used to finance introduction of the new product line must be specifically assigned to the cost of the new product line. Cost incurred by business organization always leads to cash outflows thus the interest paid must be treated as cash outflow. However, it has to be noted that that cash outflow is always recorded when cash flows out of the organization. In other words, when an organization does the real payment of expenses is when the cash flow is affected. In this regard, the interest rate will be recorded as cash flow per annum as per agreement with the lenders (Bhavesh 76). 4. Working capital is financial metric which involves operating liquidity of a business organization. It is the difference between the current assets of an organization. Bearing in mind that cash is part of the current assets of an organization, it is evidence that cash flow affects the working capital of an organization. Expansion of a business organization operation requires increase on working capital in order for the business operations to be carried out effectively. However, it has to be noted that, though cash flow affects working capital of an organization, changes in working capital has no direct impact on cash flow. In this regard, as the chief financial officer, McDonald claims, the increased working capital will have no impact on cash flow thus need not to be included in cash outflow. The percentage of working capital to cash flow per annum is likely to be the normal 40% of the company after implementation of the new product line. The increased working capital as compared to increased cash flow per annum can be computed as below. This is an indication that the new product line will increase the working capital substantially. Bearing in mind that working capital represents the hard cash which is required to carry out daily business operations, substantial increase of working capital is an indication that cash in the form of working capital will be tied up thus not being effectively used (Bhavesh 81). Working capital percentage = working capital/ average annual cash flow*100% = 200,000/ (3720, 000/10)*100% = 53.8 5. Cost which needs to be charged to a new product line is that which results due to introduction of the new product line in the organization. Use of excess production facilities and building within the organization will not lead to extra charges to the organization thus no cost should be allocated to the new product line. However, based on the assumption that acceptance of the Blast project would not affect the size of the proposed outlay and that only the timing and the new plant would operate indefinitely, the opinion on treatment of use of excess production facility and building will change based on the hypothetical projection that a new plant will be required in four years. Need for new plant in four years time is an indication that the new project is likely to increase the cost attributed to the production facilities and building. In this regard, then extra cost incurred in production facilities and buildings need to be allocated to the new product line (Patel). 6. While projecting or evaluating the performance of a certain project, the increased cash inflow of the organization in general should be utilized. In this regard, cash flow resulting from erosion of sales from current laundry detergent products should not be included as part of cash inflow of the new project. It is important to note that the new product line, Blast competes with other products of organization thus customers are likely to switch from the old product to the new product. The result of such happenings is that the cash inflow of the old products will reduce while that of the new product line will increase. In this regard, such increase in cash inflow should not be attributed to the new product line since it does not increase the aggregate cash inflow of the organization (Patel). 7. Cash Flow Statement Details current Year 1 (000) Year 2(000) Year 3(000) Year 4(000) Year 5(000) Year 6(000) Year 7(000) Year 8(000) Year 9(000) Year 10(000) Initial cost 2,000 Cash sales 380 380 380 380 440 440 440 300 300 300 Less cash outflow Interest 180 180 180 180 180 180 180 180 180 180 Depreciation (25%) 500 375 281 211 158 119 89 67 50 38 Pre-tax income -300 -175 -81 11 102 141 171 53 70 82 Tax expense 0 0 0 3.3 30.6 42.3 51.3 15.9 21 24.6 Net income (300) (175) (81) 7.7 71.4 98.7 119.7 37.1 49 57.4 Adjustments Add back depreciation 500 375 281 211 158 119 89 67 50 38 Add Salvage value 100 Net cash flow (2000) 200 200 200 218.7 229.4 217.7 208.7 104.1 99 195.4 List of assumptions 1. The amount of sales was collected fully each year thus sales has been assumed to be cash sales of the year. 2. The tax rate on net income is 30%. 3. Depreciation rate of the equipments and facilities is 25% on a reducing balance. 4. Interest rate on loan is 12% on a fixed rate. 8. Payback Period Year Net Cash flow Balance Current (2,000,000) (2,000,000) 1 200,000 (1,800,000) 2 200,000 (1,600,000) 3 200,000 (1,400,000) 4 218,700 (1,181,300) 5 229,400 (951,900) 6 217,700 (734,200) 7 208,700 (525,500) 8 104,100 (421,400) 9 99,000 (322,400) 10 195,400 (127,000) Net Present Value Year Net cash flow Discounting factor (12%) Present value Current (2,000,000) 1 (2,000,000) Year 1 200,000 0.893 178,600 Year 2 200,000 0.797 159,400 Year 3 200,000 0.712 142,400 Year 4 218,700 0.636 139,093 Year 5 229,400 0.567 130,070 Year 6 217,700 0.507 110,374 Year 7 208,700 0.452 94,332 Year 8 104,100 0.404 42,056 Year 9 99,000 0.361 35,739 Year 10 195,400 0.322 62,919 NPV (905,017) IRR NPV = -2,000,000 +200,000/ (1+r) 1+200,000/ (1+r) 2+200,000/ (1+r) 3+218,700/ (1+r) 4+229,400/ (1+r) 5+217,700/ (1+r) 6+208,700/ (1+r) 7+104,100/ (1+r) 8+99,000/ (1+r) 9+195,400/ (1+r) 10 = 0 Year Net cash flow Discounting factor (1%) Present value Current (2,000,000) 1 (2,000,000) Year 1 200,000 0.990 198,000 Year 2 200,000 0.980 196,000 Year 3 200,000 0.971 194200 Year 4 218,700 0.961 210,171 Year 5 229,400 0.951 218,159 Year 6 217,700 0.942 194,717 Year 7 208,700 0.933 194,717 Year 8 104,100 0.923 96084 Year 9 99,000 0.914 90,486 Year 10 195,400 0.905 176,837 NPV (230,629) Profitability Index Profitability Index = Present value of future cash flows/present value of initial investment = 1,094,983/2,000,000 = 0.55 Critical analysis of the different methods of evaluation of projects indicates that Blast product line is not a viable investment for the company. According to payback period method, the project will not be able to cater for its initial cost even after operating for 10 years. The net present value method doesn’t even support the implementation of the project since the NPV is negative after 10 years of operation. The IRR also does not favor the implementation of the project since the IRR is significantly less than the cost of capital. Moreover, the profitability index method does not support the implementation of the new project since its PI is lower than 1. In this regard, the project is not a viable one for investment (Capital Budgeting Methods). 9. While making decision on whether to implement a certain project, various factors need to be considered. One of the major factors is the financial contribution of the project to the organization. Another major factor which needs to be considered is the ability of competitors to take advantage and implement similar project thus reducing the competitiveness of the organization. However, financial contribution of the project outweighs the factor of competitors investing in similar project (Introduction to Project). The major aim of business organization is to make profit thus any project which is likely to cause losses to the organization during its lifetime, it should not be implemented. In this regard, the Blast product line should not be implemented by the company. As far as NPV method is concerned, only those projects which have positive net present value are supposed to be implemented. In this regard, the Blast product line should not be implemented at all unless the company comes up with other strategies of minimizing its cost of operation (Net Present Value and Capital Budgeting). 10. While making financial decision concerning viability of a project, it is essential to consider various internal and external factors which may affect the cash inflow and outflow of the project in future. The management team of the company is able to manage the internal factors but external factors can only be controlled through establishment of effective strategies which can minimize or even eliminate the negative effects of the external factors. However, due to rapid changes of external factors, it becomes hard for financial managers of an organization to forecast accurately the cash flow of the organization. Cash flow forecasting beyond five years of operation of the project has high probability of being inaccurate since various external and internal factors are subjected to significant changes which can not be foreseen (Myers). Inflation is one of the major factors which affect the cash flow of an organization significantly. In this regard, inflation should be put into consideration while making decision on implementation of a new project. Increase in inflation rate is likely to lead to devaluation of future cash flows thus should be considered as part o f discounting factor while computing net present value of the project (Net Present Value). In this regard, though analyst may predict zero long-term inflation rates, it is important for financial managers to provide a certain provision for increased inflation rate in future. For instance, if inflation rate is expected to be 5% in future, this rate need to be added to the cost of capital in order to come up with effective discounting rate of the future cash flows. In this case, the discounting rate of cash flow of the new project should be 17% (Introduction to Project). Works Cited Bhavesh, Peter. Project Management: Strategic Financial Planning, Evaluation and Control. New Delhi: Vikas Publishing House, 2000. Brigham, Gapenski. Intermediate Financial Management. 6th ed. Fortworth: The Dryden Press, 1999. Capital Budgeting Methods. 7 November 2007. 11 April 2009. . Introduction to Project Evaluation and Analysis. 2008. 11 April 2009. . Myers, Score. ‘The Capital Structure Puzzle.” Journal of Finance. 39.1(1984): 575-592. Net Present Value and Capital Budgeting. 2003. 11 April 2009. . Patel, Bhavesh. “A Value Addition Measure for Capital Project Evaluation.” The Journal of Applied Business Research. 18.4 (2004): 55-69. Read More