Assignment

PHONE is a small manufacturing company based in Perth CBD. The company manufactures high quality iPhone covers. The company's product ranges are made from elastomer, a synthetic rubber- like polymer, with the high ends are uniquely finished by skilled craftsmen.

PHONE is proud to offer a large variety of designs to suit customers' taste and budget. The company constantly adds new products to its list. The company also has its own in-house designs making the products exclusive master pieces.

Freddy Smith, a famous designer who founded the company is also the chief executive officer (CEO). He has invested his life-savings to start the company four years ago. By the end of 2016 financial year, the company recorded a cumulative sales turnover of more than $3 million with profits in excess of $1 million. In 2016 alone, PHONE recorded revenues of $1.1 million.

The management wish to expand PHONE'S product offerings to include new silicon-based iPhone cover. The new product will cost more, but is superior to the existing elastomer-based cover.

As a recent business graduate working as a financial analyst at PHONE, you are tasked to analyse the project and present your findings to the company's executives. Your preliminary work on the proposed project reveals the followings.

1. A production facility for the new product line will be set up in an unused section of the company's main plant. The company will buy a new machine for $975,000 inclusive of shipping, installation and commissioning costs. This machine will have a useful life of 9 years, depreciated on a straight-line basis. At the end of year 9, the machine is expected to fetch a salvage value of $140,000. The management has been advised that the new machine will have to be overhauled at the end of year 5 at a cost of $100,000 to extend its working condition. The cost of the overhaul can be further depreciated on a straight-line basis for the remainder of the machine's life.

2. The management is concerned with a huge amount of initial capital expenditure in the proposal 1. There is a possibility that the new product may not be as well received by the already saturated iPhone cover market. They are also aware of an alternative which is to buy a pre-owned machine that are expected to last for 4 years. This option will cost the company $470,000 inclusive of installation and commissioning costs. It is expected that the machine can be depreciated on a straight-line method with zero value at the end of its useful life.

3. If the company goes ahead with this new production of silicon-based cover, the raw material cost is expected to increase by $125,000 at the start of the first year. A supply contract for this material includes consideration for the impact of inflation on. The management make an allocation for the inflation at a rate of 2% p.a. starting from the end of the first year.

4. PHONE will utilise an unused section of its production plant for this project. The space has been unused for several years and consequently has suffered some deterioration. As part of a routine facility improvement program, the company spent $80,000 to rehabilitate that section of the plant last year. The company's accountant, Mr Bart Simon believes this paid outlay to be recognised as an expense for tax purposes, and should be charged on the silicon iPhone cover project. However, he also contends that if the improvement had not taken place, the firm would have to spend the funds anyway.

5. The company expects to sell 450,000 units of silicon iPhone covers each year at a price of $3.50 a piece.

6. The new production will also incur an additional $150,000 p.a. in fixed costs. Variable costs are expected to be $1.90 per cover.

7. The company will also set aside $30,000 at the start of each year for additional advertising and marketing expenses for this new product line. These revenue and cost projections are all pre-tax estimates.

8. PHONE is subject to the same tax rate on its ordinary incomes and capital gain. As of Sep 2017, the tax rates from Australian Taxation Office are:

Source: Australian Taxation Office.

9. PHONE is a financially sound private company and consistently profitable. However, cash on hand is not sufficient to cover the capital expenditures for this new project. Nevertheless, Mr Smith is confident that part of the project's cost can be financed through a new bank loan. The company has recently paid in full an existing 10% fixed rate loan. Preliminary discussions with the company's bank reveals that PHONE is able to secure a ten-year loan at a fixed rate of 9% p.a. with interest payable at the end of each year and the principal owing at maturity.

10. At present, the company's total assets on the balance sheet amount to $8 million. Because the previous bank loan has been fully paid, the company's equity value matches its asset value. PHONE shareholders have a 12% p.a. required rate of return for investing in the firm.

11. If the silicon iPhone covers project is undertaken, the firm will borrow $2 million from the bank. This newly added liability is expected to raise shareholders' required rate of return to 14% p.a.

The executive committee wants to see some type of risk analysis on the project. You meet with the marketing and production managers to determine cash flow estimates. After several sessions, they concluded that the following variations on the original estimates should be considered:

12. Unit sales at the end of the first year for the new silicon designed iPhone covers product can increase by about +35% if market conditions are optimistic, or fall by about -35% if market conditions are pessimistic.

13. Depending on consumer trends and competition, the firm can raise the $3.50 sale price by +20% (at the end of the first year) under optimistic estimates, or be forced to decrease the sale price by -20% under pessimistic estimates.

14. The costs of raw materials are largely influenced by the availability of the silicon which could vary by -30% p.a. and +30% p.a. from the start of the first year under optimistic and pessimistic conditions, respectively.

15. After reviewing the data provided, you realise that the revenue and cost figures have not been adjusted for inflation which is expected to average 4% p.a. over the long term. The revenues are expected to increase at a rate of 4% p.a. by the end of the first year. Fixed, variable and marketing/advertising costs for the new product are expected to increase at a rate of 2.5% p.a. from the initial cost estimates because these are largely fixed by contracts.

Your task as a financial analyst is to prepare an investment proposal to Mr Smith and the executive committee of PHONE. Your proposal should indicate whether the firm should go ahead with the new silicon product. You must also discuss which of the following alternatives is advisable.

Proposal A: The company purchases a new machinery immediately or,

Proposal B: The company should purchase the pre-owned machine first, then switch to a new one at the end of 4 years. (Note: the capital costs are not affected by inflation)

You are also required to provide summaries of the risk analyses for sensitive variables and inform management of break-even sales volumes and prices. Your proposal should address the list of requirements below.

a. Calculate the appropriate Weighted Average Cost of Capital (WACC) for the company if this project proceeds. Apply this rate as the project's required rate of return.

b. Prepare the incremental cash flow tables for Proposal A and B. Assume revenue and cost estimates from note 5, 6, and 7. Include adjustments for inflation in your cash flow forecasts. Discuss if the following items should or should not be included in the incremental cash flow tables.

i. Interest expenses on the $2 million loan;
ii. The $80,000 spent last year to rehabilitate the plant; and
iii. The reduction in sales of existing products and associated production costs.

c. Using the base-case scenarios, determine the NPVs and IRRs of this project. On the basis of these measures, should the project be undertaken? And if so, which option is more profitable for the firm?

d. Consider the impact of unequal lives for Options A and B. Does this change your recommendation in (c)?

e. Consider the sensitivities of the project's value against variations to: unit sales, sale price per cover, and costs of raw materials. Advise management which two variables will need to be scrutinised carefully if the project is implemented.

f. Using the base-case scenarios for Options A and B, determine:

i. how low sales volume will have to fall to,
ii. how low sales price will have to fall to, and
iii. how high variable costs will have to rise to;

before the project becomes unfeasible to the company. Discuss how this impacts your recommendation in (d).

g. Without any calculations, the company would also like you to start a preliminary discussion on whether the machine for this project, either in option A or B, should be leased or purchased outright. Your discussion should consider the advantages and disadvantages of adopting an operating or finance lease for the machine. Address how a lease arrangement might change your analyses.