When a company takes a decision to diversify its operations, it needs to make some investments in order to finance the decision. In order to take an investment decision for a project, financial analysis of the project is required. An analysis is required to assess how much initial investment is required for the project and when the project will begin to generate some sort of revenue for the company in order to cover the costs and ultimately at what point the project will start generating profits for the company. Contented milk cows is considering acting as a distributing agent for a foreign producer of the robotic milking system that is looking for a distributor to sell its product line in the United States. Andrew, the sales manager is required to prepare a financial proposal to assist the management of the intended milk cows in making a decision whether to take on this product line.
Andrew is required to analyze the project financially and make some recommendations to the management of the contented milk cows about the financial viability of the project. The whole purpose for this analysis is to advise and convince the management about the feasibility of taking on the new product line. For this purpose, Andrew has forecasted the financial performance of the project for the next ten years and has evaluated some figures in order to convince the management of the company. Forecasted Cashflow statement and income statement has been prepared in order to determine if the proposal is financially advisable or not.
The annual sales quantities of the robotic milking systems is expected to be 10 systems in year 1, 20 in year 2, 305 in year 3, and 40 in years 4 through 10. Meanwhile, based on the data provided the gross profit for the next ten years of the new product line has been calculated. Forecasted gross profit is expected to increase by 50% in the year 2 when compared with the year 1. Gross profit is also showing and increasing the trend in the year 3 and year 4. But the return from the project is constant from year 4 onward to year 10, with no increase in gross profit during these years. As the revenues and costs are both showing the same trend therefore, the gross profit margin of the project is 32.5% throughout the entire life of the project. Based on these calculations, the project can be accepted as it is providing a huge return to the company when the effect of cannibalization on the existing product line is ignored.
Another approach which can help the management to make an investment decision on the new product line is net present value (NPV). NPV approach is used to determine the feasibility of the project. NPV takes an estimate that how the project is valued today, either the project is profitable or feasible enough to take a start on. NPV method considers investing and financing side of the project and then the values are discounted using weighted average cost of capital (wacc). If the net of investment and financing sider after discounting is NPV. If the NPV of the project is positive then the project should be accepted as the project is not loss-making. On the other side if the NPV is negative then the project should not be accepted as the project is loss making.
In case of contented milk cows, The NPV of the project is $3,886,178. The project is giving a huge return and is highly feasible for the company to start with the project. The project is highly advisable to the management of the contented milk cows as the project will certainly add value to the company and it would also help the company to diversify its business. Inflows from the financing side of the project are admirable and are providing a cover blanket to the investment phase of the project. Therefore, the management should take a step to start the project and diversify its business.
Q2. Summarize the financial resources that will be needed to fund this (how they will be obtained is not to be addressed)
Every project needs an investment. When the management of a company has decided to take on the new project line then the other step which management should be concerned about is how to finance the project. A project can be financed through different sources of finance. Management identifies different sources of finance available to the organization in order to finance the project and then takes a decision that which financial resources will be in the best interest of the organization. Financial resources can be obtained from internal as well external sources to the company.
The project can be funded through various financial resources. Some financially resources are already available to the company like retained earnings of the company. The company has an option to convince its shareholders for not announcing dividends this year. As the company is going to start a new project which could have a strong impact on the financial strength of the company so that the retained earnings of the company can be utilized to make investments for the project. It is the responsibility of the management to convince the shareholders by providing information which can be relied upon and can assist shareholders to trust the management. This might be done by promising some bi reward for the shareholders in the coming future, in case if the project succeeds and provides high return to the company.
Like internal sources of finance, there is wide range of resources that can be acquired externally. The company can raise capital by issuing its shares in the market. This can be done by either cash offerings in the market, share for share exchange or through bond offerings. Issuance of shares in order to raise money is the cheapest source of financing the project from external sources. It can provide cash to the company without any cost and at reduced required rate of return, i.e. cost of equity. The only cost which the company need to bear is the cost of equity which the company will have to pay to its stock-holders annually in the form of dividends. This method of raising finance is highly preferable as there is no need to provide the securities and no interest charges are applicable as in the case of debt financing. Further, issuance of shares improves the debt equity ratio of the company which means that the company is less subjective to risks.
The company can take loan from the bank in order to raise the finance for the new product line. This will help the company to tackle the problem of dilution of shareholders’ power in case of issuing shares for the purpose of raising finance for the company. Moreover, the company can issue long-term bonds for the purpose of getting money from external sources. However using debt for financing has a tax advantage in that interest payments are deductible. This tax deduction is a source of value for the company.
If the company does not want to dilute the power of the existing shareholders then it can offer a right issue to its existing shareholders in order to raise finance. Right issue gives the existing shareholders an option to buy the offerings of the company at a price less than the market. So this option can be availed if the company don’t want to go for a public offering and wants to stay with the existing shareholders.
The proposed product will require additional storage and showroom space. A new corporate warehouse will be needed to receive shipments form the foreign manufacturer and service the regional offices. The central warehouse will store all the modular components that compose a robotic milking system. Designs for systems will be received from sales people and a shipment with all the required hardware will be assembled and shipped directly to customers where CMC staff will assemble it. Therefore the company might enter into some lease agreements in order to meet the demand for additional storage capacity. The company has already leased 20 regional offices but additional space for a demonstration capability, repair part storage, and a repair area is needed. Therefore, it is feasible for the company to enter into some hire purchase agreement in order to finance the new product line.
Q3. Cite potential risks and what potential financial effects could these have?
The potential risks associated with the project should be identified by the management of the company. It is the responsibility of the management of the company to assess the project financing risks and it is an important component of the project management process. The purpose of assessing potential risks is to identify the factors that could affect the outcome of the project based on the financial resources available to that project. It is important to develop a timeline that how much investment will be needed to fund the project and which would be the best available source of finance to the company.
The potential risk associated with issuing shares of the company is that it can dilute the power of the existing shareholders. Moreover, if the management of the company is unable to convince the shareholders about stating the new product line then there will be a conflict of trust between the management and owners of the business. Therefore, it would not be possible for the management to continue with the project.
Taking loan from the bank in order to finance the project is an expensive source of financing, having certain potential risks associated. Bank demands security so that it can protect its loan against that security. Moreover bank need an assurance that the project will continue for long term, and brought some positive return to the company, until the loan gets matured. Interest rate associated with costs heavily to the company depending upon the risk of the project. As the business is new for the contented milk cows and there is a possibility that the business idea might be flawed. Therefore, it is very difficult to convince the bank for reduced interest rates on the loan provided.
A company needs to take into account the gearing level of the company capital. If company raises too much of debt in order to finance the project then the gearing of the company would increase. More the gearing level of the company more the company is subject to high risk. Similarly Lease agreements also demands annual installments and it would be difficult for the company to pay the lease rentals if the projects fails in the future.
Project finance risks also have certain other risks that have the potential to undermine the performance of the company, such as loss of key personnel involved in the repairing and maintenance of the robot milking machines, Technology advancement and other anticipated issues such as change in the economic environment, political upset and change in the rules and regulation of international trade. In order to tackle the problems associated with the project and by keeping in view the uncertainty of the forecasting of the project, the management needs to establish some sort of backup funding available all time throughout the entire life of the project.
Q4. Summarize any non-financial considerations that need to be considered when making an accept-reject decision
When taking an investment decision, financial consideration are not enough to decide the feasibility of the project. However, there are certain other non-financial factors which contribute to take an evaluation that either the project should be accepted or rejected. Triple bottom line approach helps to take a decision about making an investment.
The underlying principle is that in order to evaluate a company’s true performance and assess the risks to the, investor, one must look at a corporation’s social, economic and environmental performance. Under the triple bottom approach, decision making should ensure that each perspective of the business is growing at the expense of the other. That is economic performance should not come at the expense of the environment or the society. The triple bottom line approach can be defined conceptually as economic prosperity, environmental quality and social justice.
Social factors include assurances of food safety after highly public problems such as food recalls and contamination of food. The company should ensure before accepting the project that either it has enough workforces available for the project? What would be the motivational level of the employees by the decision? Would the workforce be overburdened? And most importantly how the shareholders of the company will respond to the project?
The workforce of the contented milk cow is going to be over-burdened due to the introduction of the new product line into the business as the management is deciding to provide training to the existing employees of the company about the new product line introduced. The motivational factor of the employees is an important factor in the better performance of the company. If the employees are not motivated and are over-burdened then it could have some worst effects on the performance of the company. Therefore, the management needs to ensure the proper training of the employees before accepting or rejecting the project and it needs to resolve the issues of over-burdening. Similarly shareholders of the company are the most important stakeholders which have instead their money into the business for the purpose of getting return in the form of dividends. If the management is unable to convince the shareholders about the investment then it could have severe effect on the acceptance and rejection of the project.
PESTEL analysis is a useful checklist for general environmental factors which can affect the decision making process of the company. Government regulation and policies effect the whole economy, and governments are responsible for enforcing and creating a stable framework in which the business can be done. Contented milk cow is introducing a new product line in USA and it would be the matter of concern that how the government regulations respond to this Robot milk machine. Political factors might influence the business environment as a whole. Political risk in a decision is the risk that political factors will invalidate the strategy and perhaps severely damaging the project. Examples are wars, political chaos, corruption and nationalization. Therefore any government regulations and political chaos can affect the decision making about accepting or rejecting the project.
The economic environment affects firm at national and international level, both in the general level of economic activity and in particular variables, such as interest rates and inflation. Uncertainty in the forecasting of the project and demand of the product is obvious and therefore it can let the management to re-think about the decision of investment in the project.
Technological developments can affect all aspects of business, not just product and services. The impact of recent technological change also has potentially important social consequences, which in turn have an impact in the business. Technological factor of the new product line into the business will definitely motivate the management of the intended milk cow to accept the opportunity to act as distributor of the advanced robotic milk machines.
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