Finance and Accounting - Term Paper Example

? Finance and Accounting Table of contents Introduction 2 Cash flow ment for the first year of operations 3 Sensitivity Analysis 6 Cash flow statement for ten years of the operations of Mr. George 11 Upfront fee payable to SwissChoc SA 14 Rate of return on investments 17 Recommendations & Conclusion 18 References 19 Introduction Mr. George is planning to set up a business to import chocolate from Switzerland and sell it in the USA through internet and credit cards. The business proposal for retailing of fine Swiss chocolates given by George has been analyzed based on the information provided. SwissChoc SA (owned by a family friend) is prepared to give him exclusive rights to sell their products in the USA for a ten year period in return for an upfront payment. “The distributor is an independent selling agent who has a contract to sell the products of a manufacturer. The distributor cannot represent him- or herself as the producer but may display the producer's trade name in signage and in the sales situation” (US Legal, 2012). Since the information provided is not adequate, we have to make certain reasonable assumptions while working out the statements required in this respect. However, the lack of details in these areas is not materially going to affect the reliability of the statements. The assumptions made in this connection have been stated in the report to enable the user to bring in additional details, if it is felt necessary to have a more detailed report on the project. There is uncertainty in the price front as the details given with regard to prices at which the product could be sold are not specific. Instead George has given a price range with minimum and maximum prices for the products to be marketed. There are difficulties in predicting the correct prices due to interplay of the brands, price levels (cheap and costly with various price levels in between), market segments, tastes and flavors. Therefore, sensitivity analysis has been undertaken to highlight impacts due to variations in price realization with justifications for adopting a particular method for working out the reasonable upfront fee payable to the manufacturer – supplier SwissChoc SA and the return on investment that could be expected from the business venture of George. Cash flow statement for the first year of operations In The Statement – I, “Cash flow statement for the first year of the operations of Mr. George”, while considering various factors contributing to the cash flow, both in flow and out flow we have made certain assumptions after carefully considering various implications related to the business. Sale Price: The sale price is considered at $ 135 per kilogram of the chocolate. This is the mean price as per the price range given by George adopted for the purpose of our calculations. The mean price is worked out as below. Highest price = $ 150 Lowest price = $ 120 Average price adopted for calculation = (Highest price + Lowest price)/2 or (150 + 120) / 2 = 135. The chocolates are consumed mostly by the college and school going students. If the tastes and flavors are acceptable to them pricing is not going to be a prohibiting factor in taking a buying decision by them. Since George is an experienced person with business school background along with his wife, his price estimates should be realistic. Moreover, the Swiss made chocolates are reputed for their taste and quality. Therefore, there will not be any resistance from the parents for their children eating these chocolates. The price comparison for this product would be very difficult as in the case of other fast moving consumer goods with different brands and varieties. The George’s internet business model by marketing completely through credit cards means that the people targeted are high end and sophisticated customers, where the quality and service are more important rather than the price. Therefore, adopting the average price, if not the highest price would be very reasonable. Capital account of George: The amount shown under capital account is a balancing figure George needs to bring in for investment to start the business. The initial investment included refrigerator, development of website and average stock of four weeks’ sale. Cash flows: The statement shows month wise inflow and outflow for the first year of the operations. Purchase: Initial stock and monthly purchase/sales are worked out as under. Expected sales in one week = 30 kilograms Expected sales per month = 30/7 x 30 or 128.6 grams, Say 130 kilograms Average stock of 4 weeks’ (or 30 days approx.) sales is maintained on the first day of the business during the year by placing order for 130 kilograms on 16th of the month ‘0. 1st order is made for 130 kilograms on 16th of the month '0 and thereafter, the order will be placed for 65 kilograms on 1st and 16th of every month and the amount should be paid in advance. Quantity ordered in kgs. 130 Price 100 CHF Less: Discount @ 40% 40 Net price per kg. 60 Total price in CHF 7800 Total price in US $1.0768/CHF 8399.04 The exchange rate adopted 1CHF = $ 1.078 from the data available in the Money Converter as on 5th December 2012. Apart from the expenses as furnished by George, the following business expenses are assumed to be relevant and necessary for running an organization. Electricity, Conveyance and Telephone expenses: Normal establishment charges should be considered for realistic estimate of the profitability in business. Packing and miscellaneous expenses: Since the sales are made through internet, the packing and forwarding charges are involved. Therefore, these expenses have been estimated to the best of our judgment and included for the purpose of analysis. Sensitivity Analysis The business situations are beset with uncertainties due to various factors. In the case of new businesses the future demand patterns will be difficult to predict accurately. While working out the profitability of the project and making feasibility study the business analysts face two types of problems generally. The first one is lack of availability of certain data related to the business and secondly the uncertainties involved in the project. Koller (2005, p. 229) states “Sensitivity analysis aids in identifying the elements of a risk model that were most and least important to the calculation of the answer. Following a risk-model run, examination of the sensitivity plot can be a fundamental step in deciding what action to take as a result of the analysis.” The uncertainties may be arising out of several inputs involved in the project. The different uncertainties in the inputs have different impact on profitability as well as feasibility of the project. Sensitivity analysis is undertaken with a view to testing the outcome by adopting different parameters, levels or ranges in the business operations. “Sensitivity analysis provides a method of assessing the amount of risk involved in a proposed project. Sensitivity analysis also involves calculating the impact of variations on different quantifiable components of a project, helping management identify potential pitfalls. Management may also use sensitivity analysis to identify components of a plan that, when changed even slightly, will most impact the outcome of a project” (Symes, 2012). It is essential to understand the relationships existing between the different variables by adopting different ranges or levels of the activities, say, sales, availability of raw materials or availability of skilled labor. For example, it will be useful to make analysis with reference to the limiting factors or bottlenecks which could be resolved either by making additional investment or by outsourcing. The process of sensitivity analysis seeks to reduce the level of uncertainty. In this project the information with regard to the place of business is not given. It is not clear whether George is going to operate from his home or open separate office for this purpose. However, it is given to understand that he needs no external assistance to conduct his business. Secondly, the entire business is carried out through internet and credit cards. He is planning to develop a website for his business operations. Therefore, the place of business is not considered important. The maximum stock carried in the business at any point of time would be less than 200 kilograms which could be stored in his residence. The refrigerator proposed to be bought can be installed in his residence. Though the complete information required in this regard is not available, we can make certain reasonable assumptions. Also, this factor is not going to influence the profitability of the business to a great extent. However, the uncertainty with regard to sale price is a cause for concern. George has indicated the price range as $120 to 150 per kilogram. It could be assumed that in a worst case scenario it will fetch $120 and at the best $150. George has a very long experience in business. He and his wife have studied in the business school. The chocolates are freely available in all retail shops, and the price differentiation in the products could be mainly due to brand value. The products of SwissChoc SA are already marketed in Europe and the Swiss Chocolates are known for their taste and quality and they have established reputation in the world market. Therefore, his estimated selling price range would be reliable for the purpose of calculations. Once George start marketing his product, approximately in a year the price discovery process will be over and the price will get settled by that time. Thereafter, price is no longer an uncertain input. Therefore, for the purpose of sensitivity analysis we have considered the lowest price as well the highest price along with the mean price for understanding the impact of ‘price’ factor in the proposed business. It could be observed from the statement – II that the income from the operations during the first year works out to 187200 at the sale price of $ 120 per kilogram. The expenses incurred are completely variable or direct in nature as given below: Purchase 130 kgs 100788 Air-freight @ CHF 10/$10.768/kg. 16798 Credit card commission @ 2% of sale 4212 Salary 60000 Electricity, conveyance & telephone 6000 Packing & Miscellaneous exp. 1200 Total expenses 188999 Prima facie, it looks like there is loss in the business. However, of the total expenses the salary component works out to about 31.75%. The salary levels should be viewed in the context of the business. In practical terms, a small business cannot fulfill Georg’s expectations in the first year of the operations. The profit level is appeared to be reasonable in view of the lowest price adopted for the purpose of calculations. However, it does not mean that we have to adopt only the lowest prices for calculations. A businessman is running the risk of losing a good business opportunity by being very pessimistic in his approach. Considering the quality and reputation of the Swiss Chocolates, and the superior business model proposed for its distribution we can consider the mean price, because highly optimistic view in business is also fraught with dangers of making wrong capital investment decisions. The increase in revenue on account of increase in prices is the differentiating feature in the case of adopting mean price or higher price as the case may be. The increase in profit at gross level before depreciation and taxes as in the case of lowest price works out to $ 23400 in the case of adopting mean price and $ 46800 in the case of adopting highest price both compared to adopting the lowest prices. The depreciation and taxes have been duly considered for working out the upfront fee payable to SwissChoc SA and Return on Capital Employed, in the other statements. Statement – II Cash flow statement for the first year of the operations of Mr. George Sensitivity Ananlysis Price Price Price at $ 120/kg at $ 135/kg at $ 150/kg Cash in flow Capital Account of George 40000 40000 40000 Sales 187200 210600 234000 Total 227200 250600 274000 Cash out flow Investments Refrigerator 10000 10000 10000 Development of website 2000 2000 2000 Upfront payment 17000 17000 17000 Expenses Purchase 130 kgs 100788 100788 100788 Air-freight @ CHF 10/$10.768/kg. 16798 16798 16798 Credit card commission @ 2% of sale 4212 4212 4212 Salary 60000 60000 60000 Electricity, conveyance & telephone 6000 6000 6000 Packing & Miscellaneous expenses 1200 1200 1200 Closing cash/bank balance 38201 61601 85001 Total 227200 250600 274000 Cash flow statement for ten years of the operations of Mr. George In the Statement – III, Cash flow statement for ten years of the operations of Mr. George (Excluding upfront payment), we have made the ground work necessary for determining the reasonable upfront fee payable to SwissChoc SA and working out the rate of return on investment available as per the proposal. “In probabilistic net present value (NPV) analysis, expressed in terms of bene?ts and costs, the expected value and variance of the net present value are determined from the expected values and variances of the bene?ts and costs and correlations between bene?ts and costs. Two types of correlation are present: • Intercomponent correlations: correlations between the individual bene?t and cost components at the same time period. • Intertemporal correlations: correlations between bene?t and cost components at two different time periods” (Johar et al, 2010, p. 181 &182) For working out NPV in the present case, cash flows during the entire period of ten years for which George has rights for distribution consequent upon an agreement with the Swiss chocolate manufacturer need to be considered. These cash flows should be discounted by applying proper rate to find out the net present value of the inflows and outflows. This is necessary for realistic estimation of the rate of return available in the business. The sales and purchase figures are modified from the second year and depreciation of refrigerator and amortization of website development expenses both at 10% and taxation at 30% are considered additionally in this statement. Discount rate: Discount rate of 5% has been adopted as per the indications given. For a long term projections the rate indicated seems to be very reasonable. Purchase: In addition to the method used for calculation of purchase for the first year of the operations already given, purchases for the years 2 to 10 has been worked out as under. Calculation of purchase (2 to 10 Yrs.) Expected sales for 1 week in kgs 40 Expected sale per month 40/7x30 171.4 Say, in kgs. 170 Quantity ordered in kgs. 170 Price in CHF 100 Less: Discount @ 40% 40 Net price per kg. 60 Total price in CHF 10200 Total price in US $ @ 1.0768/CHF 10983.4 per year 131800 Depreciation: Depreciation is considered at 10%. The depreciation does not involve cash outlay. But, George can invest the amount provided for depreciation systematically in the interest bearing instruments for replacing the refrigerator at the end of the tenth year. Amortization website development expenses: “IAS 38.57 states that an intangible asset arising from development (or from the development phase of an internal project) is recognized as an asset…” (Price Water House Coopers, 2008, p. 1) As in the case of depreciation, the intangible asset of website is amortized over 10 years and the treatment given to provision for depreciation is applicable for this investment as well. Upfront fee payable to SwissChoc SA The profitability of the business has been analyzed with a view to ascertain the reasonable upfront fee payable to SwissChoc SA. For this purpose, the present value of the net cash inflow for the 10 years has been calculated as per the statement – III, using the discount rate of 5%. There are two steps involved in the calculations. 1. Ascertainment of average return on investment excluding cash outflow in respect of upfront fee payable. 2. Calculation of excess return on investment over and above the normal rate of return. This will form the basis for calculation of the reasonable upfront fee payable. Though the discount rate adopted for the purpose of arriving at the net present value of the cash flows is 5%, normal rate of return expected by a promoter of the business will be significantly higher in view of the attendant risks involved in business, and the opportunity cost of the capital. The inflation factor should also be taken into account. Since the business is conducted from home, there is an involvement of Mrs. George in the business, which needs to be considered. Keeping all these factors in mind, the normal rate of return expected is placed at 10% per annum on the capital employed. Upfront fee in the business is paid mainly for the following reasons. 1. SwissChoc SA brand is reputed in the market. 2. The upfront fee is paid to obtain the exclusive rights for a ten year period. The upfront fee payable works out to 17000 at 27.5% of the super profit which will go to George. SwissChoc SA is prevented from employing another distributor for marketing its products in the USA. Also, the company cannot directly distribute its products in this territory. It is assumed that the direct orders, if any received by SwissChoc from the USA need to be handled by George. Therefore, they deserve to be paid by George an upfront fee to compensate these opportunities lost. This needs to be worked out based on the super profits estimated to be made in the business. It is reasonable to expect that this super profit is shared between George and SwissChoc SA as per the workings furnished. Statement – IV Workings for Upfront fee payable to SwissChoc SA and Rate of return on investment Excl. Upfront fee Incl. Upfront fee Investments 12000 12000 Upfront fee 17000 Total investment 12000 29000 PV of all net inflows (ROI) 88024 78836 Average ROI per year 8802 7884 Normal return on investment 1200 2900 Excess over normal return 7602 4984 27.5% of the excess returns of George 1673 Say 1700 Excess return available for George 5930 Upfront fee for exc. Rights for 10 years 17000 Return on investment to George 27.18% (Normal + super profits) Rate of return on investment Statement – V, Cash flow statement for ten years of the operations of Mr. George takes into account all the expenses, depreciation, amortization and taxation as well as the upfront fee payable to SwissChoc SA and amortization thereof to make assessment of the rate of return more realistic. It is important to note that the upfront fee payable to SwissChoc SA needs to be treated as an asset for the purpose of analysis, and amortized over the useful life of 10 years accordingly. The rate of return is at 27.18%. It should be remembered that the average sale price at 135 has been used for the purpose of analysis. This rate of return will improve considerably, if the demand for the products improved over a period of time. The expected revival in economy in future years will increase the profits substantially. Recommendations & Conclusion The exact upfront fee payable depends upon the terms of agreement with SwissChoc SA. George should ensure that the assumptions made in this regard are reflected in the agreement correctly. The statements have been prepared based on the business environment as assessed by George and the demand pattern existing currently in the market. Therefore, we have not considered any advertisement expenses for promotion of the product. Consistent market development activities could improve the sales. However, the sales projections are maintained only at the levels indicated by George for all the ten years. Provisions made in respect of depreciation and amortization could be invested in the interest bearing instruments consistently by way of prudence. References Johar, K, Carmichael, DG & Balatbat, MCA, 2010, A Study of Correlation Aspects in Probabilistic NPV Analysis, The Engineering Economist: A Journal Devoted to the Problems of Capital Investment, 55:2, 181-199. Koller, G, 2005, Risk Assessment and Decision Making in Business and Industry, Second Edition, Taylor and Francis Group, Boca Raton. Price Water House Coopers, 2008, Issues and Solutions for the Retail and Consumer Goods Industries, International Financial Reporting Standards / US GAAP. Symes, 2012, When Should a Manager Use Variance & Sensitivity Analysis? Houston Chronicle, http://smallbusiness.chron.com/should-manager-use-variance-sensitivity-analysis-15694.html The Money Converter, 2012, Exchange Rates For Swiss Franc (CHF), http://themoneyconverter.com/CHF/Exchange_Rates_For_Swiss_Franc.aspx US Legal, 2012, Distributorships and Dealerships Law & Legal Definition, http://definitions.uslegal.com/d/distributorships-and-dealerships/ Read More