Finance Analysis of Jones Limited(small, specialist marine engineering company based in Aberdeen) - Coursework Example

? Finance for Managers Jones Limited Given details can be summarised as per the following. Annual turnover -- ?4,000,000 Annual profit before tax -- ?750,000 Development costs of “Points North”-- ?25,000 New Investments Sought in capital equipments -- ?250,000 Annual production capacity – 5,000 units Equipment life – 5 years Revenue and Cost Details are as per the following. Sales price per unit-- ?95 Variable costs per unit – materials ?10 Variable costs per unit – labour ?35 Additional annual fixed cost envisaged -- ?125,000 Capital Structure Equity – 50 %, Debt - 50% Post tax interest cost – 8% Dividend –16% Answer 1. Break Even Analysis No. of units of production required to break even in a year is given as, Contribution per unit of sale= (Sales price per unit - variable cost labour per unit - variable cost of material per unit) = 95-35-10= ?50 Breakeven production in units = Fixed cost/ contribution per unit = 125,000/50 = 2500 or at 50 % of the total production. Assuming that Jones ltd. is able to sell 5000 units in a year as mentioned in the report, earnings before interest, taxation, depreciation and amortization can be calculated as Total revenue- total variable cost-total fixed cost = (95?5,000) - (45?5,000) -125,000 = 125,000 Thus, per year earnings ?125,000 Answer 2. Capital Investment Appraisal Analysis Payback period for the investment of ?250,000 needed to generate the earnings of ?125,000 Thus, will be 250,000 ? 125,000 = 2 years In another approach, Net Present Values of Profit Streams to be received in next 3 years and 5 years can be calculated to see if they are positive. New investment needed is ?250,000. If the same debt/equity ratio for financing the project i.e 50% each is considered then debt burden will be ?125,000 and that will incur 8% interest charge. The interest charge comes to ?10,000. Since the dividend declared is 16%, weighted average cost of capital employed can be taken as arithmetic mean of debt and equity for both being equal in magnitude. Thus, the cost of capital to the company for this new project is 12% amounting to ?30,000 per year. The cost of capital needs to be deducted from the yearly earnings to arrive at the net cash flow to the company and that amounts to 125,000-30,000= ?95,000 However, the net profit of the operation after interest charge comes to 125,000-10,000=115,000 The depreciation of the plant and equipment is calculated on straight line method considering its useful life of 5 years. That is calculated as ?250,000/5= ?50,000. Thus, net profit to the company after charging interest, and depreciation is ?65,000. Development cost of ?25,000 can be apportioned as per the laws towards its useful life; however, in absence of the details, we right now assume it to apportion in 5 years. Thus, development cost for each year comes to ?5,000 and can be deducted from the net profit of ?65,000. Thus, actual net profit is ?60,000. However, depreciation is not creating any cash outflow though dividend on the equity is an out flow for the company. So net cash generated to the company is ?90,000 only. (Adding depreciation of ?50,000 back to the net profit and deducting dividend of ?20,000 at the rate of 16% on equity of ?125,000) Assuming Demand Will Last for 3 Years The forecast is that the demand will last for only 3 years due to the advancement in technology, which means net cash flow of ?90,000 will be available to company for three years only. It will be appropriate to know the present worth of the cash flow generated based on the discounting factor of 12% (equivalent to the weighted average cost of capital), and the same can be given as 90,000/1.12+ 90,000 /1.122+ 90,000/1.123 =80,357+71,747+64,060 =?216,164 …………… …. (A) Assuming Demand Lasts For Full 5 Years of Equipment Life If the demand lasts for full 5 years to make a full utilization of equipment and machinery installed then the cash flow of ?90,000 will be generated for five years until the useful life of equipment and machinery. In this case, NPV can be given as 90,000/1.12+ 90,000 /1.122+ 90,000/1.123 + 90,000/1.124+ 90,000 /1.125 = 80,357+71,747+64,060+57196+51068 =?324,428 ………………. (B) Appraisal Analysis A payback period concept tells us that how quickly money invested is recovered back that is a firsthand simple approach to come to the conclusion whether money is worth investing in the said project or not. Lesser the period, the better it is. The strength of payback period is that it is easy to calculate and the weakness is that it tells nothing beyond payback period. Also it does not take into account the time value of money invested. Net Present Value informs us about the sum of all future revenue streams converted to its present value so that clear distinction can be made about ?invested and ?received without any time gap. The strength is that time value of earnings is fully reflected. The weakness of NPV method is that if discounting rate is increased even by 1percent there would be considerable decrease in NPV. Any investment analysis is made with certain assumptions. The assumptions are many and varied. In this case, the foremost assumption is that demand will not last for more than 3 years due to rapid advancement of technology. The discounting rate used makes a tremendous impact in our calculations of NPV. The discounting rate is essentially an opportunity cost of the capital. If the discounting rate applied is taken as only 8%, which is a cost of borrowing instead of 12%, the net present value of the cash flow generated will improve but not substantially. It will be appropriate to see the impact through quick calculations. With 8% discounting and for 3-year period, it can be given as 90,000/1.08+90,000/1.082+90,000/1.083 = 83,333+77,160+71,445 =?231,938 ……………. (C) And again, for 5 years useful life with 8 percent discounting, the NPV of cash flows can be given as per the following. 90,000/1.08+90,000/1.082+90,000/1.083 +90,000/1.084+90,000/1.085 = 83,333+77,160+71,445+66,153+61,253 =?359,344 ……………. (D) Tabulating above cash flow results for our clarity Net Present Value based on 3 years demand ? Net Present Value based on 5 years demand ? Present value based on 12 % discounting 216,164 324,428 Present value based on 8 % discounting 231,938 359,344 Existing Business Profit Ratio It will be appropriate to see the current state of affairs of the company from the available information. It is given that existing business has the turnover of ?4,000,000 and its annual profit before tax is ?750,000. Profit ratio before tax can be given as 750,000?100/4,000,000 = 18.75% In the case of expansion business, the sales would be sales price ? no. of units, i.e 95?5000= ?475,000 The sales of ?475,000 generate net profit after interest and depreciation of ?60,000. Thus, profit before tax is 60,000?100/475,000 = 12.63% When compared with the existing business, the expansion business does not seem to possess the same attractiveness when looked at the profit before tax to sales ratio, which is found to be way below from 18.75% to only 12.63%. Answer 3. Apprehension on Forecast Sales Price and Sales Volume It will be appropriate to look at the apprehension raised by the Managing Director of the company on achieving the forecast sales price and sales volume. Installed plant and equipment has the production capacity of 5,000 units only and demand is also envisaged as 5,000 units. That means that no spare capacity is available for the equipment to meet the demand in case if it exceeds 5000 units. Moreover, installed production capacity of equipment is so tight that it has no room for any contingencies such as breakdown, maintenance, etc. No plant and machinery can be envisaged to work at full 100 % capacity throughout the year. Further, it is a norm that any plant and equipment should have the cushioning of minimum 25 percent extra capacity to meet any unforeseen happenings. It is quite possible that demand even may exceed the forecast sales but the plant and machinery cannot supply the increased demand. This is one of the major lacunae in this new project of marine compass called ‘the Points North’ if decided to implement. Though no sufficient data are available to establish the validity of sales price and sales volume but any further reduction in sales price or sales volume will largely make the project in jeopardy. It will be appropriate to see what happens if there is 5% reduction in the sales price. Forecast sales price is ?95. If realized price is 5 percent less than the company will receive price of ?90.25 Sales revenue will be 5000 ? 90.25= ?451,250 Variable cost per unit (material and labour) = 35+10= ?45 Total variable cost for 5000 pieces, 5000?45= ?225,000 Fixed cost= ?125,000 Profit before interest and depreciation will be 451,250-225,000-125,000= ?101,250 Profit after interest charge will be 101,250-10,000 = ?91,250 Profit after depreciation will be 91,250-50,000 = ?41,250 Profit after deducting the apportioned development cost = 41,250-5,000= ?36,250 Servicing cost for equity will take away ?30,000 the net surplus will be only ?6,250 From this, it is quite clear that 5 % reduction in sales price makes this project not worth pursuing. The reduction in the price is not a big issue, if market also expands to garner more revenue. Any company in the business is interested in the absolute profit rather than unit price. The breakeven point in this case can be calculated to give number of units required as 125,000/ (90.25-45) = 2762 units Thus, breakeven point comes to 2762/5000 = 55%, which is higher by 5 percentage point from the previous breakeven point of 50%. There is a substance in the managing director’s view point that project is quite risky and to operate at forecast price and sales volume is quite challenging to make budgeted profit. Again, it should be noted that the reduced sales by 5 percentage point maintaining the forecast sales price of ?95 will also bring the same effect as calculated above from the breakeven point view. Surplus will remain ?6,250 only per year. What Happens if Sales Price and Volume Are Reduced by 5%? If the same calculation is extended further with 5% reduction in sales along with 5 % reduction in the price then the company’s operation for this product line would surely be in red as there will be 10 percent reduction in the total revenue. Quick calculation indicates the revenue of only ?427,500 and profit before interest and depreciation will be just 427500-225,000-125,000= ?77500 After interest charges on debt and depreciation the profit will be only ?17500. Apportioning development cost of ?5,000 profit remains ?12,500, which is just not sufficient to pay 16 percent dividend to the shareholders. Answer 4. A Report to Directors on the “Points North” Project Jones Ltd. has done some good research and developed a new product called the “Points North”. The product has application and market with small boat and yacht owners. This is totally a new market segment and to be served independent of the existing activities. The product cannot be manufactured using existing machineries. A new equipment and facilities are required that envisage the investment of ?250,000. The facility is sufficient to produce 5000 units. The forecast demand is also for 5000 units. The market is likely to exist for the “Points North” for 3 years after that there will be no demand for the product as new technologies that are advancing fast will in all likely hood replace the product. The investment appraisal analysis has been done with the assumptions keeping in mind the forecast sales price of ?95 and variable cost of ?45 that includes labour and material. The payback period for the investment to be made is found to be only 2 years as reported in the ensuing pages, which looks lucrative. An industry norm and investment experts usually considers a project having payback period of 3 years or less is worthy of investment. From that view point, this project passes the test and can be considered for investment. Since the project of this magnitude requires much careful thinking as it may have a long term ramifications in the overall performance of the company, its liquidity and more than that the impact it can make on shareholder’s net worth, it was decided to appraise the investment through one more criteria called NPV. Net present value takes into consideration the time value of all the future cash flows likely to incur towards the useful life of the project with the appropriate discounting factor applied to it. The weighted average cost of the capital of Jones Ltd. is 12 percent considering debt and equity involvement as 50% each and the same is used to discount the future cash flows across useful life of 3 years. The net present value of all cash flows based on above is found to be ?216,164 against the required investment of ?250,000. There is no possibility of any further cash flow generation as life of the project is 3 years. NPV analysis surely speaks about the weakness in the project. The foremost reason is that though plant and machinery has a residual life of 2 years but there will be no demand for the product to take advantage of. When compared with the existing business of the Jones Ltd, the expansion business does not possess the same attractiveness when looked at the profit before tax to sales ratio, which is found to be only 12.63% – way below the ratio of 18.75% the existing business have. The above report is based on the certain assumptions that also include 100% capacity utilization and realization of the sales price as forecast. The project does not offer any leeway or cushioning for its sales price or sales volume to survive. The appraisal indicates that even 5% reduction in the capacity utilization or in sales revenue makes this project unviable and not worthy of consideration. It is a formidable task to run the production line at 100% capacity throughout its useful life of 3 years without any breakdown or any other unforeseen issues that may evolve during this period. In view of the above, it is concluded that this project is quite risky and it is recommended not to go ahead with the project based on the existing facts and forecast figures. References Mclaney, Eddie (2009), Business Finance-Theory and Practice, Eighth Edition, Pearson Education, Essex Atrill, Peter; McLaney, Eddie (2009), Management Accounting for Decision Makers, 6th edition, Pearson Education, Essex Atrill, Peter (2009), Financial Management for Decision Makers, fifth edition, Pearson Education, Essex Weetman, Pauline,(2010), Management Accounting, 2nd Edition, Pearson Education, Essex Read More