Assignment
The Capstone Assessment follows on from the financial review of Cochlear Ltd undertaken in the First Assessment.
Cochlear Ltd understands that these days, expanding business online is not a choice but is a necessity. To overcome the challenges stemming from the COVID-19 situation, Cochlear Ltd's management team have brainstormed different options with the objective of maximising their value. It is expected that with the online presence, demand for their products would increase as more and more consumers would be able to access it. Recently you joined Cochlear Ltd. As part of the management team, you have been asked to investigate the viability of the different options.
The marketing department has done intensive research and suggested an aggressive 5-year marketing strategy whereby the credit terms to all customers will be relaxed from 30 days to 45 days, in conjunction with other marketing campaigns across Africa, Asia, and Latin America. This campaign will involve an additional marketing fixed cash expense of $160,000 per year and is expected to generate additional sales of 4,000 equipments per year.
To accommodate the extra demand created by the marketing campaign, Cochlear is comparing two mutually exclusive investment projects. The two projects A and B are outlined below.
The Project A is less risky as it would involve the expansion of existing facilities and requires an initial investment of $1Million. The Project B involves higher investment of $ 1.5 Million but reduces the current variable cost of production. Both investment projects would have a five-year usable life and would be depreciated over their life using the straight-line depreciation method (assuming no salvage value). The total annual additional fixed cost will be the sum of marketing fixed cash expense of $160,000 per year (mentioned above) and annual depreciation (a non-cash expense) for each project.
The production manager has produced estimates for the costs associated with the manufacturing of the product. The current variable cost of producing one equipment is $405, which would remain the same under Project A but is estimated to fall to $300 per equipment in the case of Project B. The total variable cost includes raw material, labour and other production costs. The selling price of the equipment is $650.
As per the above forecasts (assume they remain the same every year) and the 5-year marketing campaign, the estimated free cash flows generated by the two projects are given below:
Table 1: The estimated free cash flows for Project A and Project B
|
Year
|
Project A
|
Project B
|
|
0
|
($1,000,000)
|
($1,500,000)
|
|
1
|
$634,000
|
$958,000
|
|
2
|
$634,000
|
$958,000
|
|
3
|
$634,000
|
$958,000
|
|
4
|
$634,000
|
$958,000
|
|
5
|
$634,000
|
$958,000
|
Note: The above-mentioned estimates reflect all associated revenues/costs. Ignore the change in working capital and assume revenue/costs are constant over time.
Based on the weighted average cost of capital (WACC) of previous projects, you have estimated the required rate of return to be 8%.
To finance the marketing campaign and the expected increase in production costs, Cochlear Ltd will need to raise additional finance in the form of debt and/or equity.
Written report
I. Discuss the implications of the proposed relaxation of credit terms to customers from 30 days to 45 days on Cochlear's working capital management (Note: No calculations required).
II. Explain the usefulness of simple Payback period, and Net Present Value (NPV) as investment appraisal tools. Compute the simple Payback period and NPV for Project A and Project B and discuss which Project is better and why. Use the payback cut-off period of 2 years for the evaluation of the payback period, and 8% as the discount rate to calculate NPV. What other factors should Cochlear consider in selecting between Project A and Project B? Explain why.
III. Explain the usefulness of cash and accounting break-even points as management tools. Based on the forecasted increase in sales, do Project A and Project B meet the corresponding cash and accounting break-even points? Explain why.
IV. Using Cochlear's debt ratio and ROE and its trend over time from your first assessment, advise how should Cochlear finance the chosen project? Explain why using finance principles introduced in this subject.
V. Based on the answers to Questions I through IV above, make specific recommendations to the Board. Include limitations of the analyses conducted.