Business Studies: Case Studies Paper on Capital Formation and Corporate Management

Capital Formation and Corporate Management

Introduction

            Expert is facing a dilemma on whether to invest more capital on a Personal Digital Assistant (PDA) device brand the Bernoulli that its Chief Executive Officer Mr. Workman perceives as obsolete and should be scrapped, or eliminate the product line from the company by selling it to competitors. Jennifer a market analyst at the company is optimistic that investing $ 18 million in improving the device will help the company expand its market share and report profits in the future. Using financial facts provided, this paper decides on the appropriate cause of action considering both financial and non-financial factors.

Question 1

Sales Forecast

            Assuming the improved Bernoulli device production starts in January 2004 and actual selling starts in January 2005, revenue in year 2004 is expected to be zero for the new device. The company will continue to sell the old device at the forecasted units per year until January 2005. To manage competition, the selling price will remain at $ 495 upon introduction of the new device. Increased revenue is expected to be realized from increased unit sales. Under this scenario, annual sales forecast can be presented as:

Year 2004 2005 2006 2007 2008 2009
New Device
Units Sold “000”              –              185            250            260            260            260
Revenue  $ (Units * $495) “000”              –          91,575      123,750      128,700      128,700      128,700
Old Device
Units Sold “000”            150              –                –                –                –                –  
Revenue $ (Units*$495) “000”        74,250              –                –                –                –                –  
Total Revenue        74,250        91,575      123,750      128,700      128,700      128,700

            If Expert declines to inject more capital into the old Bernoulli product and the new device is not introduced into the market, the company will continue to sell the old device at $ 495. Annual revenue is expected to decline over the years, as market share declines. Annual sales forecast under this scenario can be presented as:

December     2004     2005     2006     2007     2008     2009
Unit Sales “000” 150 102 57 48 48 48
Revenue $ (Units*$ 495) 74250 50490 28215 23760 23760 23760

Question 2

Forecasting Costs

            Jennifer has estimated that cost of goods sold will be 54% of the selling price if the new Bernoulli is introduced into the market. Additional advertising expenses will increase operating expenses by 2% to 26%. If the $ 18 million investment is not made, the old Bernoulli will continue to incur a cost of goods sold, which is 60% of retail price, and lower operating expenses which are 24% selling price.

            In the first scenario where the revised device is introduced into the market, the company will incur costs of the old device in 2004 and start incurring new costs in 2005 henceforth, when the new product is introduced into the market. Cost of goods sold per unit will be 54% of $ 495, which is $ 267.3, and operating costs per unit will be 26% of $ 495, which is $ 128.7. In 2004, cost of goods sold per unit will be 60% of $ 495, which is $ 297, and operating costs per unit will be 24% of $495, which is $ 118.8. The company will also incur depreciation costs on the new and old investments. Depreciation on old investment of $ 56 million will be applied using the 10 year Marginal Accelerated Cost Recovery Schedule (MACR) while the 5-year MACR schedule will be applied on calculating depreciation costs of the new investment, which is $ 18 million. Cost forecasts under this scenario can be presented as:

Year 2004 2005 2006 2007 2008 2009
New Device
  Units Sold “000”           –           185         250         260         260         260
  CoGS (Units * $ 267.3)           –       49,451     66,825     69,498     69,498     69,498
Operating Costs (Units*$128.7)           –       23,810     32,175     33,462     33,462     33,462
Depreciation Rates 20% 32% 19% 12% 11%
Depreciation Cost “000” (18M*Rates)      3,600      5,760      3,420      2,160      1,980
Old Device
Units Sold “000”         150           –             –             –             –             –  
CoGS (Units*$297)     44,550           –             –             –             –             –  
Operating costs (Units*$118.8)     17,820           –             –             –             –             –  
Depreciation Rates 7% 7% 7% 7% 6% 3%
Depreciation Cost      3,920      3,920      3,920      3,920      3,360      1,680
 Total Costs     66,290     80,780   108,680   110,300   108,480   106,620

            In a second scenario in which management fails to provide $ 18 million for development of the revised Bernoulli, the company will continue to incur current costs. Thus, cost of goods sold per unit will be 60% of $ 495, which is $ 297, and operating costs will remain 24% of $ 495, which is $ 118.8. Depreciation cost will only be applied using the old MACR schedule.  Cost forecasts under this scenario can be presented as:

Year 2004 2005 2006 2007 2008 2009
Unit Sales “000”             150         102           57           48           48           48
Cost of goods Sold (Units*$297)        44,550    30,294    16,929    14,256    14,256    14,256
Operating Costs (Units*$118.8)        17,820    12,118      6,772      5,702      5,702      5,702
Depreciation Rate 7% 7% 7% 7% 6% 3%
Depreciation Cost (Rate * 56M)          3,920      3,920      3,920      3,920      3,360      1,680
Total Costs        66,290    46,332    27,621    23,878    23,318    21,638  

Question 3

Making Decision Using Discounted Cash Flow Analysis

Net Present Value

            The net present value method of evaluating capital budgets discounts future cash flows from a capital investment into their present value. The sum of these discounted future cash flows are compared to the initial capital outlay, and if they are greater than the initial investment, the project should be undertaken. Otherwise if the sum of all discounted future cash flows expected from the project is less than the initial capital outlay, investing in the project could be a potential loss to the company; thus, should be abandoned. To use this capital budgeting method to decide whether Expert should invest the proposed $ 18 million into developing the new Bernoulli, all expected future cash benefits from introduction of the new Bernoulli are discounted to their present value as at 2003 using the weighted average cost of capital, summed up and compared to $ 18 million. If they are less, Expert should continue to sell the old Bernoulli or dispose the product line, if they are more than $ 18 million, the company should invest in the new device. The future cash benefits expected from the new device are net income, that is, revenue less operating expenses and the terminal value.

            Given that the new initial investment of $ 18 million is made on December 2003, it can be assumed that it will start earning revenue at the end of December 2004. It is also assumed that the old investment of $ 56 million is not written off, and therefore the company will incur depreciation on it at 7% in 2004. A corporate tax rate of 34% has been applied on earnings before interest and tax. The new 5-year Marginal Accelerated Cost Recovery (MACR) rates are used to depreciate the new investment.

The annual net operating profit after tax is presented in the schedule below:

With new investment   Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09
Units sold (‘000) 150 185 240 260 260 260
Unit price 495 495 495 495 495 495
Revenues (‘000) 74,250 91,575 118,800 128,700 128,700 128,700
COGS (%) 54% 54% 54% 54% 54% 54%
COGS 40,095 49,451 64,152 69,498 69,498 69,498
Op Expenses (%) 26% 26% 26% 26% 26% 26%
Op Expenses 19,305 23,810 30,888 33,462 33,462 33,462
Initial Investment “000” 56000 56000 56000 56000 56000 56000
Depreciation (%) 7% 7% 7% 7% 6% 3%
Depreciation 3,920 3,920 3,920 3,920 3,360 1,680
New Investment “000” 18000 18000 18000 18000 18000 18000
Depreciation (%) 20% 32% 19% 12% 11% 6%
Depreciation 3,600 5,760 3,420 2,160 1,980 1,080
EBIT   7,330 8,635 16,420 19,660 20,400 22,980
Tax (%) 34% 34% 34% 34% 34% 34%
Tax 2,492 2,936 5,583 6,684 6,936 7,813
NOPAT   4,838 5,699 10,837 12,976 13,464 15,167

            Depreciation does not involve actual movement of cash. Therefore while calculating the actual cash flows, it is added back to the Net Operating Profit after Tax. At the end of 2009, Jennifer forecasts that the new investment can be disposed at a value equivalent to cash flow from that year divided by the Weighted Average Cost of Capital (WACC); hence, a terminal value of the same amount arises on December 2009. All these cash flows are then discounted using the formula;

Discounted Cash flow at year n = Forecasted Cash flow at Year n/(1 + WACC)n

Discounted Cash flow schedule can thus be presented as follows;

1 2 3 4 5 6
Cash-Flow   Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09
NOPAT 4,838 5,699 10,837 12,976 13,464 15,167
Depreciation 7,520 9,680 7,340 6,080 5,340 2,760
New Investment
FCF 12,358 15,379 18,177 19,056 18,804 17,927
Termination value 0 0 0 0 1,236
PV of FCF 10,812 11,772 12,173 11,164 9,639 8,039
PV of Termination Val 554
PV 10,812 11,772 12,173 11,164 9,639 8,594
Total DCF             64,153

            The total discounted cash flows from the new investment are $ 64,153,000, which is far much higher than the initial investment of $ 18,000,000. The Net Present Value being positive, Expert should invest the $ 18 million on the new Bernoulli device.

The Internal Rate of Return

            The Internal Rate of Return (IRR) is a discounting rate that when used to discount future cash flows from a capital investment, the Net Present Value becomes zero. Capital projects with higher IRR are more profitable. To make a decision on whether to undertake a single project like in the case of Expert, IRR is compared to the Weighted Average Cost of Capital. If IRR is higher than WACC, the project is potentially profitable and thus should be undertaken. Otherwise, if IRR is less than WACC it should be abandoned. IRR has no specific formula and can be arrived at by trying different discounting rates. Using a discounting rate of 80.45%, the Present Value of all future cash flows is $ 18,000,000, which is equal to the initial investment of $ 18,000,000. The IRR is thus 80.45%.

1 2 3 4 5 6
Cash-Flow   Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09
NOPAT 4,838 5,699 10,837 12,976 13,464 15,167
Depreciation 7,520 9,680 7,340 6,080 5,340 2,760
New Investment
FCF 12,358 15,379 18,177 19,056 18,804 17,927
Termination value 0 0 0 0 1,236
PV of FCF 6,848 4,723 3,094 1,797 983 519
PV of Termination Val 36
PV 6,848 4,723 3,094 1,797 983 555
Total DCF             18,000

            The Internal Rate of Return being higher than WACC indicates that the project is profitable; thus should be undertaken. Using this criterion to make a decision, it is evident that Expert should still invest $ 18 million on the new Bernoulli device.

Question 4

Making Decision

            Both Internal Rate of Return and Net Present Value suggests that the project is viable and the company should go ahead with the new $ 18 million investment. Thus, from a financial viewpoint, the proposed investment appears to be viable. However, according to Erickson (2013), during capital project assessment, management should analyze the project from other perspectives apart from a financial perspective. Management should consider the goal of the project in comparison with the goals of the company as a whole, and evaluate whether they are in agreement. Other non-financial resources that may be needed, the period that the project will be in existence and its potential long term impacts on the business, potential obstacles and how they can be solved, the level of project risk compared to returns expected from the project and availability of affordable sources of capital.

            Expert’s main objective appears to be focused on how to manage competition. They believe that by introducing the new device into the market, they will recover the lost market share. According to professional forecasts presented by Jenifer, the improved device is expected to regain the lost market share at a rate of 8% per annum. Thus, the objective of the proposed investment is in line with the goal of Expert as a whole. The firm also appears to be in financial distress given the state of its depressed stock prices that have remained low for a long time, which is a major concern for its management. To recover from this, the company needs to make high sustainable profits. From the cash flow analysis, it is highly likely that introduction of the new Bernoulli will help it earn some constant good profits in the near future. Thus, the proposed investment will help it achieve another goal, which is recovery from the financial distress, improving its public image and raising the value of its stock.

            Management must also consider the sources of capital. In this scenario, Jennifer has figured out there is enough cash to cater for the proposed $ 18 million investment within the firm; however, it is not clear whether Workman would authorize the use of such a huge sum on an investment into a product he sees as a ‘black hole of the firm’s finances’. If the project is to be implemented, management must be sure of a source of affordable capital. Jennifer has supported his forecasts with credible estimations. Moreover, she has earned a high reputation in market analysis. She is perceived by management of Expert as ‘someone who can see the future and attach numbers on to it’ and has been promoted to the position of a ‘Cost Engineer’. The management therefore has a lot of faith in her, and is likely to support her with the required capital for the proposed investment.

            Workman’s concerns however should not be ignored. His argument is that the Bernoulli device is outdated, and should be phased off. He has a futuristic view in the world of technology and to prove this, he had correctly anticipated the development of the World Wide Web. He is of the opinion that Experts should focus more on innovation and creation of new products rather than recycling old ones. According to him, the $ 18 million should be directed towards reinforcing the company’s laptop and desktop computer market share. Workman however does not provide a detailed market analysis on the financial impacts of his proposal like Jennifer does. It would be difficult to prove that investing in the laptop and desktop computer line of business would earn the company any extra returns, or higher returns than the new Bernoulli device without any credible financial forecasts on that option. Furthermore, his argument that the Bernoulli device is outdated is questionable. Technologically the Bernoulli device appears to be at par with other devices in the market. It can access the internet, and has been made compatible with other computer brands. Electronic consumers like their devices smaller, lighter and more portable. In this aspect, the Bernoulli beats many modern laptops; thus, cannot be said to be obsolete. Slight improvements on the device would put it at the edge of the latest technology thus; further investment on it is justifiable.

            Essentially, innovation is about designing new products that satisfy customer needs or making changes to an existing product so that it meets changing customer needs. This is the business approach that Workman is advocating for. He has openly asserted his desire for innovation and market leadership. The $ 18 million proposed investment on improvement of Bernoulli is thus in line with Workman’s plans. To achieve market leadership, Jennifer has forecasted that the new device will grab back the lost market share at a rate of 8% per annum. At this rate, Expert can rise to the position of a market leader in 10 to 15 years’ time from the time the new investment is made in late 2003. To satisfy Workman’s innovation concerns, the new investment will improve the old Bernoulli by making it compatible with many computer platforms, and adding more features on it that could meet customer needs, which might have changed since the old device, was introduced into the market. Workman had also made it clear that he would be outsourcing production from outside the US as major competitors were doing, to reduce production cost. In compliance with this, Jennifer had forecasted using hard figures that production of the new device would be cheaply outsourced. In fact, Workman arrived at his decision to outsource production after seeing Jennifer’s forecasts. Considering all aspects, deciding on the new investment including its potential impacts on Workman’s plans, it is clear that Expert should proceed with the proposed $ 18 million investment on the new Bernoulli.

Question 5

The Option of Selling Bernoulli

            If management decides to sell the old Bernoulli immediately after investing $ 18 million in the new product, they can recover its residue value, which has not been depreciated by December 2003. This is the total depreciation for years 2004 through 2009, which is 37% of $ 56 million. Thus, the old investment can be sold for a minimum of $ 20.72 million plus the value at which old patents and licenses will be sold. 

            Incase Expert’s management decide to sell Bernoulli production division altogether in December 2003, they would have forfeited all cash flows they would have received from selling the old device units between January 2004 and December 2009, as Jennifer forecasted. The value at which they would sell the division thus must be at least equal to the present value of all future cash flows they would have received if they maintained the division within the firm. Future cash flow schedule of the old investment can be presented as follows:

Without new investment   Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09
Units sold (‘000) 150 102 57 48 48 48
Unit price $ 495 495 495 495 495 495
Revenues (‘000) 74,250 50,490 28,215 23,760 23,760 23,760
COGS (%) 60% 60% 60% 60% 60% 60%
COGS 44,550 30,294 16,929 14,256 14,256 14,256
Op Expenses (%) 24% 24% 24% 24% 24% 24%
Op Expenses 17,820 12,118 6,772 5,702 5,702 5,702
Initial Investment “000” 56000 56000 56000 56000 56000 56000
Depreciation (%) 7% 7% 7% 7% 6% 3%
Depreciation 3,920 3,920 3,920 3,920 3,360 1,680
New Investment ‘000’ 0 0 0 0 0 0
Depreciation (%) 0 0 0 0 0 0
Depreciation 0 0 0 0 0 0
EBIT   7,960 4,158 594 (118) 442 2,122
Tax (%) 34% 34% 34% 34% 34%
Tax 2,706 1,414 202 0 150 721
NOPAT   5,254 2,745 392 (118) 291 1,400

            Discounted Cash flows;

1 2 3 4 5 6
Cash-Flow   Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09
NOPAT 5,254 2,745 392 (118) 291 1,400
Depreciation 3,920 3,920 3,920 3,920 3,360 1,680
New Investment
FCF 9,174 6,665 4,312 3,802 3,651 3,080
Termination value 215
PV of FCF 8,026 5,101 2,888 2,227 1,872 1,381
PV of Termination Val 97
PV 8,026 5,101 2,888 2,227 1,872 1,478
Total DCF             21,592

            The total value of all discounted future cash flows from the old investment is $ 21,592,000. This is the minimum amount of cash that Expert must sell the Bernoulli division. This however excludes the value of patents and licenses which could fetch extra cash if sold at the same time.

Question 6

More Factors to Consider in Eliminating Product Line or Divesting a Product Division

The Impact on Brand Loyalty

            The company should consider the level of customer loyalty to the product brand it is considering for elimination. According to Aaker (2009), it is easier to maintain the loyal customers than gain potential customers. If the company eliminates a product line, along with it, it eliminates all customers that were loyal to that brand, and it will be forced to use more resources to convince potential customers to change from their current preferences into buying the company’s new products. Thus, before eliminating or divesting a product line, the company must consider brand loyalty.

Possibility of Using the Product Line as a Loss Leader

            A company can strategically maintain a loss making product line, and use it as a loss leader. Loss leaders are products that sell below their production costs (Gitman & McDaniel, 2008). Companies hope that by selling a product so cheaply that it makes losses from it, it is increasing revenues from other products when customers come to them to buy the loss-making product and as a result buy other products too. A firm must thus consider using the unwanted product for this strategy before it decides to eliminate the product fully.

The Product Life Cycle

            Bender and Ward (2012), describe a typical product life cycle. When a product is just launched into the market, sales are low and costs are high thus the possibility of making losses. Later, revenues start to grow and profits may be realized. Sales start to dwindle as competition comes in. Managers must thus consider at which stage of the product life cycle their troublesome product is, before they decide to eliminate it. A current loss-making product could be potentially highly profitable in its later product life cycle stages.

Stakeholders’ views

            Businesses have a wide range of stakeholders both internal and external. Every decision management makes has an impact on them. Within the company, employees are the major stakeholders. Dropping a product line could have negative impact on staff morale. Some employees who  might be attached to the brand for example those who work under the product division that is supposed to be eliminated could feel threatened by the decision, start underperforming, spreading negative rumors about the company as a whole  and in the long run destroy the company image and reduce efficiency of its operations. This could have a negative ripple effect on other well performing product lines as well. External stakeholders include suppliers, customers, shareholders, the government, financers and the public at large. Management also should consider the impact that dropping a product line could have for instance, on its suppliers. To receive goods on credit on them, management must maintain with them a good relationship. Eliminating or divesting a product line could mean that the services of a key supplier to the company will no longer be required. The supplier could turn to the competitors and leave the company struggling.

            Shareholders are the owners of the company. The company must accommodate their views while making any major decision such as divesting or eliminating a product line. If they are not consulted on such major decision, in protest they could sell their shares to a competitor and in effect putting the ownership of the company in the hands of a predator. The government and local authorities’ opinion must also be considered. Under certain circumstances for example where the company is the only manufacturer of an essential product that is supposed to be eliminated, the government can offer subsidies and incentives such as tax credits for the company to continue producing the product. The company must consider these possibilities before abandoning the product. While making a decision therefore management must consider the views of every stakeholder of the company and the impact that the decision will have on them.

Conclusion

            From a financial viewpoint, Expert is better off if it invests $ 18 million in designing and producing the new Bernoulli device. Both NPV and IRR show that the capital project will be profitable in future. Selling the Bernoulli production division could only earn around $ 22 million which is far less compared to $ 64.153 million cash in present terms that could be earned from the new investment. The company should also be innovative and come up with new products to recapture the lost market share just as Workman emphasizes.

References

Aaker D.A. (2009) Managing Brand Equity, New York, NY: The Free Press. Retrieved on           February 21, 2014 from:

http://books.google.co.ke/books?id=r_TSY5sxnO8C&pg=PT62&dq=brand+loyalty+to+retain+old+customers&hl=en&sa=X&ei=dBoHU7uQJ8u60wW4pIC4DQ&redir_esc=y#v=onepage&q=brand%20loyalty%20to%20retain%20old%20customers&f=false

Bender R., Ward K. (2012) Corporate Financial Strategy (2nd ed.) Woburn MA: Routledge          Publishers. Retrieved on February 21, 2014 from:

http://books.google.co.ke/books?id=YJLoJItxFOoC&pg=PA47&dq=Product+Life+Cycle+causes+may+cause+low+sales&hl=en&sa=X&ei=myEHU4_4EeHD7AbzooGYCA&redir_esc=y#v=onepage&q=Product%20Life%20Cycle%20causes%20may%20cause%20low%20sales&f=false

Erickson K.H (2013) Investment Appraisal: A Simple Introduction. Retrieved on February 21,       2014 from:

http://books.google.co.ke/books?id=f88YAgAAQBAJ&pg=PT53&dq=list+non+financial+issues+in+investment+appraisal&hl=en&sa=X&ei=rwgGU5yNB9Kw7AbGsIGgAg&redir_esc=y#v=onepage&q=list%20non%20financial%20issues%20in%20investment%20appraisal&f=false

Gitman L. J., McDaniel C.(2008) The Future of Business: The Essentials, Mason OH: South-        Western Cengage Learning. Retrieved on February 21, 2014 from:

http://books.google.co.ke/books?id=vUdFCfnJYu4C&pg=PA309&dq=loss+leaders+attract+customer&hl=en&sa=X&ei=BhkHU9zlHKal0AXJl4HQAg&redir_esc=y#v=onepage&q=loss%20leaders%20attract%20customer&f=false