BUSINESS FINANCE CASE STUDY ASSIGNMENT -
Instructions - You must do Questions 1-5a, 8 and 10 on a spreadsheet.
Eternal Youth Ltd (EY) is a New Zealand company which produces and sells cosmetics. Its financial year is 1 January to 31 December.
Its financial position at 1 January 2018 is as follows:
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Current assets
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88,000
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Current liabilities
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55,000
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Non-current assets
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407,000
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Non-current liabilities
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165,000
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Development costs
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220,000
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Equity:
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|
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Preference capital
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132,000
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|
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Ordinary capital
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363,000
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$715,000
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$715000
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The company has carried out successful trials on a new type of skin cream, which has been developed to reduce the effects of ageing. Market research indicates that the cream is likely to have a product life of four years and could be sold to retail chemists and departmental stores at a starting price of NZ$50 per 50ml bottle in New Zealand.
During the last two years, development costs of $220,000 have been incurred for this product. These costs have been capitalised, and if production of the cream goes ahead will be amortised on a straight-line basis over the four-year life of the product.
If production of the new cream does not go ahead, these costs will be written off immediately in the 2018 financial year. Development costs are tax deductible in the year they are amortised.
If EY Ltd does launch the product, production (and therefore sales) could begin at once.
The company is considering two options.
OPTION ONE -
Produce the skin cream, and cease production of an existing skin gel.
CREAM: EY would need to purchase a new machine costing $800,000, which would be depreciated at 25% prime cost method. The equipment is expected to sell for $110,000 before tax at the end of four years.
In order to produce and sell the cream, the following changes in asset and liability accounts will result:
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Bank
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-2,200
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Accounts receivable
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+14,300
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Inventory
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+44,000
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Prepayments
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+3,740
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Accounts payable
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+33,000
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Sales of 50ml bottles are expected over the next four years as follows:
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Year
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Sales
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Sale price $
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2018
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82,500
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50
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2019
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77,000
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52
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2020
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99,000
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52
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2021
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88,000
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54
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The cream will require 1.5 hours of labour for each 50ml bottle produced. Current labour costs in 2018 are $19 per hour. Other variable costs per 50m1 bottle are expected to total $10 in 2018.
Fixed overhead costs (excluding depreciation) in the first year of production of the cream are expected to total $355,000.
The following changes are expected over the four-year period (2018 - 2021):
- Labour costs will increase by 50c per hour each year.
- Other variable costs will increase by $1 per bottle in 2020 and 2021.
- Fixed overhead costs (excluding depreciation) will increase by 4% in 2020.
GEL:
An existing machine producing skin gel was purchased on 1 January 2016 for $200,000 and is being depreciated at 20% per annum prime cost method over 5 years.
This machine could be sold on 1 January 2018 for $140,000 before tax if gel production ceases. If it is not sold on that date it is expected to have a productive/useful life of four more years. It is expected this machine would sell for $30,000 before tax at the end of 2021.
The following is the budgeted net profit before depreciation and before tax for gel if production continues.
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$
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2018
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110,000
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2019
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140,000
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2020
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120,000
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2021
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115,000
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OPTION TWO -
Continue production of existing skin gel and sell the recipe for the cream to a competitor for $330,000 before tax on 30 December 2018.
Other information: The Company undertakes projects with a payback period of less than 2.5 years, provided the NPV is positive.
EY needs to raise funds for the new machine. The company wishes to maintain the current proportions of long-term debt: equity. Funds can be raised as follows:
- It can sell four-year, $1,000 face-value bonds with an 8% annual coupon interest rate for $1,000. The cost of issuing these is $55 per bond.
- It can sell unlimited 9.5% preference shares for $5 per share, but this will cost 5% of the par value in issue costs. These shares are preferential as to both dividends and return of capital in the event of winding up.
- At the end of 2018, EY expects to pay a dividend of 14c per ordinary share. Future dividends are then expected to grow by 5% per annum.
EY's ordinary shares currently sell for $1.70 per share. New ordinary shares can be sold for the same price, but issue costs of 15c per share will be incurred.
REQUIRED:
PART A - VIABILITY OF THE INVESTMENT
1. Calculate the weighted average cost of capital.
2. Calculate:
a. the initial investment.
b. the terminal cash flow.
3. a. Identify the "sunk" cost and explain how it is treated.
b. Prepare a statement showing the operating net cash flows for the existing gel.
c. Prepare a detailed statement showing the incremental discounted cash flow statement for the cream, assuming sales commence in 2018.
4. Calculate the:
a. payback period
b. NPV
c. IRR
d. profitability index
e. discounted payback period (use your WACC calculated in 1 above)
5. One director doesn't think sufficient attention has been paid to risk. He is a director of another company that establishes "risk classes" and believes the risk of EY's new skin cream is in the "above-average risk class" and therefore the discount rate used to assess the viability should be increased jay 20%.
a. If the discount rate was increased by 20% and this director has the final "say", would EY proceed with producing the cream. Show workings.
b. Identify and briefly explain in your own words the various issues that could increase the risk of not achieving the results you calculated in (3) above and affect the viability of the investment.
c. Briefly explain why the CAPM is not really valid for assessing the risk of this project for EY. (You must provide at least 3 logical reasons for lack of validity).
6. Write a brief report, stating with reasons and with reference to your answers above which option EY should choose.
PART B - IMPLICATIONS FOR WORKING CAPITAL MANAGEMENT
7. Explain why the working capital would change as a result of producing the skin cream.
PART C - FINANCING OF THE INVESTMENT
8. Given that EY wishes to maintain the current proportions of long-term debt: equity to finance the purchase of the new machine, calculate:
a. the maximum debt that can be borrowed
b. the number of preference shares to be issued and the proceeds receivable
c. the number of ordinary shares to be issued and the proceeds receivable.
9. EY has not decided how it will finance the purchase of the new machine - assuming it buys it. Compare and contrast the following sources of finance from the company's point of view. (You need to consider advantages and disadvantages of each source).
a. Bank loan (secured over non-current assets)
b. Bond/debentures (secured)
c. Finance lease.
10. If EY Ltd did not wish to maintain its current debt: equity ratio, it could borrow from the bank and buy the new machine or it could lease it.
Option 1: Buy the machine
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Cost
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$800,000
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Estimated useful life
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4 years
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Estimated residual value
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$100,000
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Depreciation is to be based on depreciable cost Annual maintenance contract (payable at the end of the year)
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$10,000
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Loan required
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$690,000
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Interest rate on loan
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7%
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Term of loan
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4 years
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Payments
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Annual - year end
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Option 2: Lease the machine
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Annual lease payments
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$180,000
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Payments
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At beginning of each year
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Purchase option at end of lease
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$15,000
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Annual maintenance contract (payable at the beg. Of the year)
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$10,000
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EY will not exercise the purchase option at the end of the lease.
Required:
a. Determine with reasons whether EY Ltd should buy or lease the machine. Show all your workings clearly.
b. What non-financial factors would EY also consider when making the decision on whether to lease or buy the new machine? Give reasons for your answer.