Fundamentals of Value Creation
Goodhealth Drinks Company was formed in 1985 and is a leading producer of fresh, frozen and made-from- concentrate citrus drinks is Australia. The company’s founder, Mr Charles Harvey invested in citrus land located in the south-west region of Western Australia. Mr Harvey initially sold his oranges and grapefruit to wholesalers but when juice sales were expanding, he joined with several other producers to form Goodhealth Drinks Company, which then expanded into juice processing. By 2010, the company had a sales turnover of over $10 million with profits with excess of $ 1 million.
Goodhealth’s management is currently evaluating a new product, fresh lemonade. The new product will cost more, but is superior to competing lemonade products made from reconstituted lemon juice. As a recent business school graduate working as a financial analyst at Goodhealth, you must analyse the project and present the findings to the company’s executive committee.
Production facilities for the fresh lemonade line would be set up in an unused section of Goodhealth’s main plant. Relatively inexpensive used machinery with an estimated cost of $500,000 would be purchased, but shipping and installation charges will add another $50,000 to the total equipment cost. Inventory will have to be increased by $20,000 at the start of the first year, then by 10% p.a. thereafter. The machinery has a remaining economic life of 4 years, and the company expects to apply a straight-line depreciation schedule. At the end of 4 years, the machinery is expected to have a $40,000 salvage value.
The section of the plant where the lemonade production would occur has been unused for several years and consequently has suffered some deterioration. As part of a routine facilities improvement program, Goodhealth spent $80,000 to rehabilitate that section of the plant last year. The accountant, Mr Kevin Smith, believes this outlay which has already been paid for an expensed for tax purposes, should be charged to the lemonade project. His contention is that if the rehabilitation had not taken place, the firm would have to spend $80,000 to make the site suitable for the lemonade project. Smith also informed you that a neighbouring citrus processor had expressed an interest in leasing the lemonade production site for 4 years. The terms of the lease agreement would be a fixed rental of $10,000 p.a. payable in advance and a deposit of one-year rent as bond would be returned at the end of the lease.
The company expects to sell 350,000 cartons of the new lemonade product in each of the next 4 years at a price of $4.50 per carton, but $2.00 per carton would be needed to cover the fixed and variable cash operating costs. The company will also set aside $15,000 for additional advertising expenses for this new product line. While examining the sales figures, you noted a short memo from Goodhealth’s sales manager expressing concern that the fresh lemonade project would cut into the firm’s existing sales of frozen lemonade. Specifically, the sales manager estimated that frozen lemonade sales would fall by 5% if fresh lemonade were introduced. You then talked to both the sales and production managers, and they concluded that the new project would probably lower the firm’s frozen lemonade sales by $50,000 p.a. but at the same time, it would also reduce production costs for frozen lemonade by $35,000 p.a., all on a pre-tax basis.
Goodhealth is a private company, soundly financed and consistently profitable. Cash on hand is not sufficient to buy the used machinery. However, Mr Harvey is confident that part of the project’s cost can be financed with medium-term debt, privately placed with an insurance company. Goodhealth had borrowed via a private placement once before when it negotiated a fixed rate of 10% p.a. on a five-year loan. Preliminary dicsussions with Goodhealth’s bankers led Mr Harvey to believe that the firm could arrange a four-year 12% p.a. medium- term loan with repayment of fixed annual interest expense and the principal owing at maturity. The company’s tax rate is 30%.
At present, the company’s total assets on the balance sheet amount to $5 million. Of this, $2 million comprises of the five-year loan with an interest charge of 10% p.a. The principal of this loan is due to be repaid in three years. The balance of assets is funded by equity, and shareholders have a required rate of return of 16% p.a. If the fresh lemonade project is undertaken, the firm will borrow $250,000 via the second medium-term loan under the
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terms specified above. The balance of the necessary funds will be provided from retained earnings. The added liability on the firm’s balance sheet is expected to raise shareholder’s required rate of return by 1 percentage point.
The executive committee wants to see some type of risk analysis on the project as it might be profitable, but there are chances that it might turn out to be a loser. You met with the marketing and production managers to get a feel for the uncertainties involved in the cash flow estimates. After several sessions, they concluded that the following variations on the original estimates should be considered: • Unit sales can rise by about +20% if market conditions are optimistic, or fall by about -20% if market conditions are pessimistic. • Depending on consumer trends and competition, the firm can raise the $4.50 sale price by +10% (after year 1) under optimistic estimates, or be forced to decrease the sale price by -10% under pessimistic estimates. • Inventory costs are largely influenced by crop yields, and could vary by -20% p.a. and +20% p.a. under optimistic and pessimistic conditions respectively. • The salvage value of the machine is also uncertain. At best, the firm may be able to dispose of the asset for $80,000 but there is also a likelihood the firm cannot find a buyer for the machinery at all.
After reviewing the data provided, you realise that the revenue and cost figures have not been adjusted for inflation which is expected to average 5% p.a. over the next 4 years. Specifically, the sales price of $4.50 per carton is expected to increase at a rate of 5% p.a. after Year 1. On the other hand, operating costs, inventory and advertising expenses are expected to increase at a rate of 2% p.a. from the initial cost estimates because these are largely fixed by contracts.
Your task as a financial analyst is to prepare a capital budgeting report to Mr Harvey and executive committee of Goodhealth Drinks Company indicating whether the firm should accept or reject the lemonade project. You are also required to provide summaries of the risk analyses for sensitive variables and break-even sales volume and prices. Address the following:
1. Estimate the appropriate Weighted Average Cost of Capital (WACC) applicable as the project’s required rate of return.
2. Prepare the incremental cash flow table for the fresh lemonade project over the first four years of operations based on annual sales quantity of 350,000 cartons. Include adjustments for inflation in your cash flow projections. Discuss if the following items should be included (or excluded) in the cash flow statement: (a) The interest expenses on the $250,000 loan; (b) The $80,000 spent to rehabilitate the plant; (c) The reduction in Goodhealth’s frozen lemonade sales and associated production costs; and (d) Opportunity of leasing the lemonade production site for $10,000 per year.
3. Assume the company uses a payback rule with a cut-off period of two years. What are the payback period, net present value (NPV), internal rate of return (IRR) and profitability index (PI) of this project? Should the project be undertaken based on each of the investment evaluation methods? Discuss.
4. Evaluate the sensitivities of the project’s NPV against variations to: unit sales, sales price per carton, inventory costs, and the salvage value. Advise management which two variables will need to be scrutinised carefully if the project is implemented.
5. Determine the break-even sales volume and break-even sales price in order for this project to be viable, under the expected cash flow projections.
6. Suggest two possible risks or opportunities that may impact the feasibility of continuing with the fresh lemonade line after 4 years. Discuss two project options the firm could consider which can impact your earlier valuation of the project.
Question 1 WACC calculation
Question 2 Discussions Incremental cash flow table
4 marks 15 marks
Question 3 Project evaluation and discussion
Question 4 Sensitivity analysis Discussion of results
8 marks 2 marks
Question 5 Break-even sales volume Break-even sales price
2 marks 2 marks
Question 6 Discussion of risks, opportunities and project options
Marked out of 50, scaled to 25% of final grade
1. Your discussions should not exceed 1000 words (4 pages). This is based on a 12pt. Times New Roman font with 1.5 pt paragraph spacing. 2. Turnitin only accepts the submission of one document. Copy all Excel tables and paste them as a picture (JPEG) in your Word document. This minimises the chance of a viewing error after uploading on Turnitin.
A template for what your submission should comprise of…
An executive summary (the body of your discussions) This section is should be an arrangement of your discussions from your analysis. Clearly state: – your recommendations to management of Goodhealth Drinks Company on whether the firm should proceed with the investment project, based on the findings of PB, NPV, IRR and PI. – your assumptions on items included and excluded from the incremental cash flow analysis and why (as per Question 2). – advise to management on which variables the project’s success is most sensitive to and the relevant break-even levels (as per Questions 4 and 5). – potential risks and opportunities of the firm going beyond 4 years with the product, and suggest two project options which have not been considered but can impact the valuation of the investment (as per Question 6).
Supporting calculations (your workings) All relevant tables and cash flow workings should be attached at the back of your document. These must correspond to your discussions. Ensure information is neatly and clearly presented. Your grader will evaluate the calculations as per what is presented in the document. So make sure that whichever Excel workings you deem suitable to include are visible in the Word report.