Financial Management

Fin" rel="nofollow">inancial Management Case Study Sprin" rel="nofollow">ing 2016 Rich Confectionaries Company John Rich the co-owner of Rich Confectionaries and plant manager picked up the telephone to call the firm's Sales Manager. The Sales Manager had sent him an email suggestin" rel="nofollow">ing that Rich Confectionaries might be able to in" rel="nofollow">increase its profits substantially if he were allowed to in" rel="nofollow">increase the production capacity for a new home brand chocolate that he planed to in" rel="nofollow">introduce for sale in" rel="nofollow">in convenience stores. The plan was to provide convenience stores, like “7 eleven” with their own brand of chocolate for sale at the counter. It would be a high-margin" rel="nofollow">in product that was currently bein" rel="nofollow">ing sold in" rel="nofollow">in bulk to large department stores for their own use in" rel="nofollow">in house brandin" rel="nofollow">ing sales. If they went ahead with this new product the company would be able to sell the new product at a higher price than the current price to department stores. The Sales Manager was really pushin" rel="nofollow">ing this poin" rel="nofollow">int to John, however his real motivation was that he was bankin" rel="nofollow">ing on gettin" rel="nofollow">ing a big in" rel="nofollow">increase in" rel="nofollow">in his bonus payment. "Your suggestion in" rel="nofollow">interests me," said John Rich, "but I can't give you an answer until the fin" rel="nofollow">inancials have been worked up to show that profits from the in" rel="nofollow">increased sales you expect to get will give us a big enough return on our capital in" rel="nofollow">investment”. As soon as you have firm estimates for sales and how much you will need for advertisin" rel="nofollow">ing and promotion, give them to Stephanie Rich (the company's controller and another major owner). She can get the other data she needs to make the calculations from purchasin" rel="nofollow">ing and production, and I will ask her to send me her recommendation by early next week. If it is as profitable as you thin" rel="nofollow">ink it will be, we will move on it immediately." Rich Confectionaries has been in" rel="nofollow">in busin" rel="nofollow">iness at the same location for over 80 years. It was the first chocolate company to locate in" rel="nofollow">in the Blue Mountain" rel="nofollow">ins for the cooler temperatures for storin" rel="nofollow">ing chocolate, and it remain" rel="nofollow">ins by far the largest family producer of confectionaries in" rel="nofollow">in the country. Although the company has entered in" rel="nofollow">into a number of licensin" rel="nofollow">ing agreements with overseas producers it contin" rel="nofollow">inues to operate as a family run busin" rel="nofollow">iness. In addition to the title of plant manager, John Rich also serves as a member of the board with his sister and other family members. The Rich Confectionaries factory produces a large range of products, from standard family block chocolate, to elaborate commemorative chocolate pieces. Approximately 40 percent of the plant's current output is sold under the Rich Confectionaries label, with the remain" rel="nofollow">inin" rel="nofollow">ing production sold in" rel="nofollow">in bulk to department stores. The product lin" rel="nofollow">ine in" rel="nofollow">in which the Sales Manager wants to expand production was first in" rel="nofollow">introduced in" rel="nofollow">in 1989 under the Rich Confectionaries brand name, but its real sales growth came in" rel="nofollow">in the late 1990s. At that time, contracts were signed that provided for bulk delivery to several large department stores for brandin" rel="nofollow">ing and sale under their own labels. In the past few years the Sales Manager has had in" rel="nofollow">inquiries from several other companies about similar arrangements, but the present production facility is already producin" rel="nofollow">ing at its full designed capacity. Before writin" rel="nofollow">ing the email to Rich, the Sales Manager had discussed the expansion idea with another family member who is on the board who is also head of the production department. Accordin" rel="nofollow">ing to Production Manger there is no room to expand production capacity in" rel="nofollow">in the present factory. The factory is located in" rel="nofollow">in a small in" rel="nofollow">industrial zone at Sprin" rel="nofollow">ingwood several kilometres from the main" rel="nofollow">in plant at Katoomba. Other tenants presently occupy all of the available land and buildin" rel="nofollow">ings adjacent to the Sprin" rel="nofollow">ingwood operations. However, the production manager has heard of a company that is goin" rel="nofollow">ing in" rel="nofollow">into receivership, whose manufacturin" rel="nofollow">ing plant is very near the main" rel="nofollow">in factory and this factory space should become available for lease very soon. This factory space has the required floor space, power, water and gas supplies already in" rel="nofollow">in place that Rich Confectionaries needs, and it can be leased for 10 years at a rental of $325,000 per year. "I have wanted to get rid of that stupid small factory for years it costs me a fortune in" rel="nofollow">in sendin" rel="nofollow">ing main" rel="nofollow">intenance staff over there" said the production manager. "It is a real in" rel="nofollow">inconvenience for me to have to go all the way over there whenever they have a problem and they have quite a few sin" rel="nofollow">ince they have to operate at full capacity all the time. Movin" rel="nofollow">ing to a location practically across the street from the main" rel="nofollow">in plant and expandin" rel="nofollow">ing capacity would really make thin" rel="nofollow">ings easier for me. You can count on my help in" rel="nofollow">in convin" rel="nofollow">incin" rel="nofollow">ing the board to make the move." Workin" rel="nofollow">ing with Production Manager, the Sales Manager prepared some prelimin" rel="nofollow">inary estimates on the back of a scrap piece of paper, which showed a payback in" rel="nofollow">in less than one year. This was based on sales of 100,000 units at $100 per presentation box givin" rel="nofollow">ing $10 million of in" rel="nofollow">income less expenses of around $6.6million, thus the net profit would be $3.3 million with an in" rel="nofollow">initially outlay of only $2.7 million. As he gave this quick calculation along with more detailed supportin" rel="nofollow">ing documentation to Stephanie Rich, the Sales Manager remarked that a one year payback was hard to beat. He also noted that the production manager wanted to move on the project quickly, so he hoped that Stephanie would not delay in" rel="nofollow">in passin" rel="nofollow">ing the proposal on to John with her full support “it was in" rel="nofollow">in the family’s best in" rel="nofollow">interests”. After glancin" rel="nofollow">ing at the detailed figures in" rel="nofollow">in appendix 1, Stephanie noticed several problems. First, the sales and expense numbers discussed are not expected to be achieved until Year 5. Hence, the apparent profitability is probably overstated. Second, they represent total sales and expenses. Rich Confectionaries is already producin" rel="nofollow">ing 50,000 units per year in" rel="nofollow">in its existin" rel="nofollow">ing location, and Stephanie believes that it would be improper to use profits on existin" rel="nofollow">ing sales to justify the expansion. In other words, what she needs is an in" rel="nofollow">incremental analysis of the costs and benefits that are associated with makin" rel="nofollow">ing the move and that would not occur if the proposal is rejected. Third the estimates did not in" rel="nofollow">include the $500,000 in" rel="nofollow">in market research the Sales Manager had spent over the past two years researchin" rel="nofollow">ing this idea which had culmin" rel="nofollow">inated in" rel="nofollow">in his proposal. The figures for the first few years shown in" rel="nofollow">in appendix 1 represent an in" rel="nofollow">introduction period in" rel="nofollow">in which marketin" rel="nofollow">ing efforts are to be directed at several potential key customers. Stephanie knew that sales in" rel="nofollow">increases of this order of magnitude would require substantial amounts of new workin" rel="nofollow">ing capital. From other expansion decisions that had been undertaken in" rel="nofollow">in the past, Stephanie estimated that the current level of $450,000 would be sufficient if the move is not made to the new location. However if the move is made, a total of $540,000 will be needed at the begin" rel="nofollow">innin" rel="nofollow">ing of the first year. As sales will in" rel="nofollow">increase in" rel="nofollow">in year three, this figure will in" rel="nofollow">increase to a total of $720,000 at the start of Year 3, and a further in" rel="nofollow">increase to a total of $900,000 at the start of Year 5. Stephanie also questioned the Production and Sales Manager about the old plant and equipment, some of which is to be moved from the old to the new facility. They advised the old plant would have to be scrapped, as it will not meet the new production figures. “It is fully deprecated on the books and also for taxation purposes but could be sold for $175,000 today. The new plant would cost $2.5 million. However the chocolate moulds, cookin" rel="nofollow">ing pans and wrappin" rel="nofollow">ing equipment will be moved to the new facility. It is still on the books at a value of $150,000, which is also its tax book value. The depreciation for management purposes and tax is $50,000 per year for the next three years. It will cost us $50,000 to move them to the new buildin" rel="nofollow">ing, and rein" rel="nofollow">install. If we wanted to get rid of it and buy all new equipment, I could probably sell it for its book value, but the new equipment we would have to buy costs over $500,000. I see no reason to replace the moulds, pans or wrappin" rel="nofollow">ing equipment sin" rel="nofollow">ince it is all in" rel="nofollow">in good shape and will last the ten years." All agreed it would be silly to sell the old chocolate moulds, cookin" rel="nofollow">ing pans and wrappin" rel="nofollow">ing equipment and then replace them with new that was just wastin" rel="nofollow">ing $350,000 for no extra benefit. Both Stephanie and Sales Manager agree that the new facility should be able to operate profitably for many years. The Rich board had decided that a study life of ten years, the standard used by the company, would be employed in" rel="nofollow">in the analysis. At the end of ten years, the market value of the plant is estimated to be $500,000 but the equipment (chocolate moulds, cookin" rel="nofollow">ing pans and wrappin" rel="nofollow">ing equipment) will be worth nothin" rel="nofollow">ing. It is assumed that the full value of the workin" rel="nofollow">ing capital can be recovered. When evaluatin" rel="nofollow">ing capital projects Stephanie uses a real cost-of-capital of 15 percent and a tax rate of 30 percent. Rich Confectionaries also has a company policy of usin" rel="nofollow">ing straight-lin" rel="nofollow">ine depreciation for management reportin" rel="nofollow">ing purposes over the life cycle of the product. Under the tax guidelin" rel="nofollow">ines, the new equipment is classified as a five-year asset and is eligible for a 20% straight-lin" rel="nofollow">ine depreciation rate. Additional Information . All costs and in" rel="nofollow">income figures are in" rel="nofollow">in constant dollars at 2016 levels. . Company tax rates are 30% and paid at the end of year. Rich Confectionaries expects to be payin" rel="nofollow">ing tax at the company tax rate of 30% in" rel="nofollow">indefin" rel="nofollow">initely. . The expected in" rel="nofollow">inflation rate for the next ten years is expected to be 3% pa. . Removal and relocation costs are an allowable expense for tax purposes when paid. . Debt fin" rel="nofollow">inance costs 10.5% pa for companies like Rich and the loan repayments if Rich borrowed the funds would be $449,000 per year for ten years Exhibit 1 All Figures Constant Dollars Estimated Sales, Production Costs, Marketin" rel="nofollow">ing Expenses and Other Expenses Sales Estimates Boxes Revenues Marketin" rel="nofollow">ing Expenses Status quo Sales at $80 per box New Facility Years 1–2 50,000 @ $80 10,000 @ $110 Years 3–4 50,000 @ $80 25,000 @ $110 Years 5 -10 50,000 @ $80 50,000 @ $110 Cost Estimates 50,000 60,000 75,000 100,000 $4,000,000 $5,100,000 6,750,000 9,500,000 $87,500 $487,500 $387,000 $153,000 Variable Costs Annual Fixed Costs per Box Lease Deprtn.* Other# Status quo New Facility Years 1-2 Year 3 Year 4 Years 5-10 $60.00 $59.00 $56.00 $56.00 $50.00 $100,000 $325,000 $325,000 $325,000 $325,000 $50,000 $320,000 $320,000 $270,000 $270,000 $125,000 $300,000 $300,000 $300,000 $300,000 *These amounts are for reportin" rel="nofollow">ing purposes and are based on a 10-year life, straight-lin" rel="nofollow">ine rates, and zero salvage values. # The amounts in" rel="nofollow">include in" rel="nofollow">in status quo an amount of $50,000 per year representin" rel="nofollow">ing actual cash cost for in" rel="nofollow">inter-factory transfers/transport which in" rel="nofollow">includes main" rel="nofollow">intenance staff, transfer of parts and raw materials. Also in" rel="nofollow">included under New Facility “Other”, there is an amount of $5,000 per year representin" rel="nofollow">ing the amortisation of the removal and relocation expense for the moulds, pans and wrappin" rel="nofollow">ing equipment. The Sales Manger’s scrap paper workin" rel="nofollow">ings QUESTIONS • Identify the in" rel="nofollow">incremental cash flows for this project (ie produce a table of the in" rel="nofollow">incremental cashflows for capital budgetin" rel="nofollow">ing analysis). Please use the excel you marks (13 marks) • Write a brief executive summary to John Rich givin" rel="nofollow">ing your recommendation? Include a summary of your workin" rel="nofollow">ings supportin" rel="nofollow">ing your recommendation. Make sure you look at the guide to writin" rel="nofollow">ing assignments on how to do an executive summary which must not be more than one page in" rel="nofollow">in length (3 marks) • Sales Manager used the payback period as an in" rel="nofollow">indicator of the merit of the move to the new facility. Is this decision criterion the one that should be used? Give reasons why you would use this criterion and one why you would not. (2 mark) • What others factors should Rich Confectionaries consider? (2 marks)