Managerial Finance in a Health Spa Resort - Assignment Example

Managerial Finance Introduction Serene Hall, a health spa resort is located in the centre of England. Today’s hectic lifestyle most certainly requires an antidote to replenish the mind & soul, and Serene Hall exploited this business opportunity successfully. Apart from the advantage in respect of location, Serene Hall enjoys the grandeur of a large stately home which has been renovated to create perfect ambience for the premier health spa it has become today. Serene Hall is now operating with a full order book. In the face of looming competition, the company has decided to revamp its operations and in this respect formulate a suitable strategy, taking into account the escalating demand for the services provided by the Health and Beauty sector in the leisure industry, with the aim of sustaining growth and strengthening its market share. “The method a company uses to expand its business is largely contingent upon its financial situation, the competition and even government regulation. Some common growth strategies in business include market penetration, market expansion, product expansion, diversification and acquisition”. (Suttle, R., 2012) The following important issues have been identified, in connection with the strategies to be evolved, during the discussions at board level. 1. Uncomfortable debt levels – Finance Director 2. Better marketing can boost profits - Marketing Director 3. Cost reduction – Operations Director Since the order book is already full, the strategies to be implemented with the existing facilities will not have any significant impact on growth or increasing the market share. The company needs to introduce new services like full body massage and relaxing head jobs keeping in tune with the emerging demands. Better marketing and cost reduction exercises could not improve profitability dramatically as the company in these cases cannot push beyond certain limits. The idea of bringing down the debt level, so that the company can plough back the profits generated for investment, is not consistent with the objectives of growth and increasing market share, which calls for new investment. The company needs to think about new strategies to improve profitability and market share. It is in this backdrop, the following strategies have been put forward for consideration after discussion between the board and the management team. 1. Acquire the assets of suitable competitor(s) to strengthen the market share. 2. Invest in upgrading Serene Hall facilities in an attempt to attract new customers and retain exciting ones. 3. Withdraw from the market and close the facilities. This paper seeks to analyze the above strategies and advise the company with regard to the advantages and critical issues related to the strategies put forward and the strategy best suited for the company for achieving its objectives of growth and increase in market share in the long run. I – Acquisition of the assets of the competitor(s) It is proposed to acquire the assets of the company New You. Smith, H.T.J. & Moraitis, T. (2009, p.86) state “The traditional logic of an acquisition is based on inter-assets synergies that are expected to arise when the merged organisations can support activities more profitably in combination than they could separately.” New You is a major player in the industry with a market share of 28% as given in Exhibit 1. The workings as per Statement-I clearly highlights the profitability of the proposal under various options. Demirakos, E. G. et al (2004 p. 238) states “the types of valuations used to justify analysts recommendations depend on characteristics of the company being analyzed”. Based on the details furnished and stability and growth prospects of the industry, for the purpose of analysis we have used Net present value method. According to ‘differencebetween.net’, “Net Present Value is really a component of Discounted Clash Flow, which makes it more difficult to make out the differences. The NPV is a central tool used in DCF”. The following assumptions have been made while working out the proposal. 1. Interest rate for the purpose of calculation is adopted at 10%. 2. Taxation has been considered at 25%. 3. It is stated that the improved market prices due to reduction in competition result into additional cash inflows at 10.6 m annually for 5 years. However, it is expected that this benefit will not suddenly stop and it is assumed that it might taper off by 20% per year from the 6th year as shown in cash flow. 4. However, if it is felt that in view of uncertainty, additional cash flows should not be taken into account after 5th year, the Statement-II could be used for taking decisions where additional cash inflow is not considered from the 6th year. 5. Cost of saving on amalgamation is treated as inflow, instead of showing it in out flow as negative figures. 6. The provision for redundancy and relocation and other contingencies have been considered appropriately in the statement as per the estimates given. 7. Research and development cost to be incurred has not been considered for the purpose of calculations, as it is not related to acquisition. 8. Purchase consideration is taken at £45m being the average, i.e. £50m - £40m 9. For investment purposes, the “life” of the project is assumed to be 10yrs. Advantages in the proposal In the case of option 1 Serene Hall would be able to increase capacity and market share through the control of major competitor New You. It would mean that Serene could start to expand throughout England to an already existing market. The acquisition would reduce the number of competitors and thus reduce the risk of margin erosion due to competition. The target company New You has not really invested enough to provide the whole passive atmosphere that is so relished by those who are on the go, twenty four-seven. Sheeba, K. (2011, p.654) state “Synergy in M&A is simply the additional value created on combination of two or more firms, which is more than the sum of value created by each individually”. The acquisition of New You is expected to create synergy in operations which would enhance the enterprise value as a whole. Cookson, I. (2006, p.10) states, “the plan for delivering intended synergies, not only in regards to cost savings through consolidation, purchasing synergies, etc., but also pertaining to those actions intended to expand revenue”. The combined entity of Serene Hall and New You would give a market share of 49.2% as indicated in the Exhibit 1. The increased market share ensures stability in the operations. Exhibit 1 Leisure Industry – Health & Beauty Sector Major Competitors Projector Market Share 2004 Company Name Health & Fitness Body Treatments Natural Healing & Alternative Therapies (includes detox) Market Share% Serene Hall 32 37 10 21.2 New You 34 28 60 28.0 Old Hag 12 4 27 8.6 Rags2Robes 10 10 10 8.6 Good Looks 4U 13 18 12 10.0 Other 30 30 23 23.6 % of total sales 47 25 28 100 The company’s portfolio of the services after amalgamation expands considerably. This will enable cross selling of the services. Also, as a dominant player in the industry, the company could enjoy pricing power for its services. The acquisition improves the operating leverage of the company, because fixed costs may not increase with the sales volume. Khan, M. Y. & Jain, P. K. (2011, p.18.4) state “The operating leverage may be defined as the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and tax.” In view of the relatively risky nature of the project, the finance director of Serene Hall asserted that the “normal” hurdle rate of 8% should be increased to “10%”. Though this has ignited some debate amongst the management team, we have considered the rate of interest at 10%. Therefore, the rate of return worked out based on net present value method, even as per Statement-II, stands at 3.94 (4.87 as per Statement-I) on a conservative basis, after taking into account the effect of all variables known, and the uncertainties provided for. Alberto, C. (2005, p.1) states, “The concept of NPV is the brick of a normative building deep-rooted in the maximizing tradition of economics”. The appointment of three additional directors with a promise of bonuses could be efficiently justified on the grounds that their services could be optimally used in a bigger undertaking with expanded portfolio of services, because the bonuses would be based on the incremental profits only and not based on the current profits. The statement “These are to be based on return on investment and profit growth figures” forms the basis for bonus. II - Investment in upgrading the existing facilities The second option open to Serene Hall is to invest in an upgrading exercise. As demand for simple relaxation and beauty enhancement is rapidly increasing, and at the moment demand is exceeding supply, it would seem logical for Serene Hall to expand its existing facilities. One suggestion is to convert the two old barns to the side of the Hall into rooms overlooking the terrace and formal grounds. These can then be used to house the current detox/colonial irrigation fad. Market research is suggesting that the demand for such facilities is likely to carry on increasing over the next 10years. The rate of return on the investments is calculated as per Statement-III. The following assumptions have been made while working out the proposal. 1. The initial investment will cost £60m, spread over three years. 2. If Serene Hall chooses this option then they can benefit from an annual cash inflow of around £18m – starting in year 3 at the earliest. 3. Interest rate for the purpose of calculation is adopted at 10%. 4. Taxation has been considered at 25%. Advantages in the proposal The Investment in upgrading the existing facilities is spread over three years. The investment could be made to a greater extent from the internal accrual. The existing assets are effectively used in creation of new facilities. Since borrowings required, if any, will be limited, the interest burden will not increase significantly. The average rate of return per annum works out to 5.37% as shown in Statement-III. III - Closure of the business The third and final option is that of ‘’withdrawal’’ from the market. This is essentially a retreat strategy in the face of competitive pressure. According to the information given, the Health and Beauty sector in the leisure industry is sitting comfortable, but not without severe competition, enjoying increasing profits, as the population becomes more and more health and appearance conscious. The spa provides for a variety of clientele, offering top of the range services in an attempt to de-stress, relax and revitalize their customers. Service / facilities offered range from an effortless stroll around the stupendous grounds, offering, even today well maintained refreshing wood forest walks to the more rigorous work outs in the Gym, naturally desired for. And if all you want is to be pampered, then the list of treatments from which you can choose is endless. The company has grown quickly, mainly due to family ownership keeping costs tightly under control. The growth in this industry, despite a general downturn in the economy as a whole, has only help facilitate the profits of Serene Hall. It has been clearly stated that “demand for simple relaxation and beauty enhancement is rapidly increasing and at the moment demand is exceeding supply”. Going by the above picture, consolidating the company’s position in the industry by adopting suitable strategies keeping in mind the level of competition and increasing demand, to achieve the objectives of ‘growth and increase in market share’ is the need of the hour. Justifications against closure This option would generate cash of around £63m less closure cost of £14m - both spread over 3 years. The present value of the net inflow is less than the debt in the books, i.e. £50 million. The Marketing Director’s concern: ’We will have wasted a lot of money and lose all our loyal customers to New You’ is genuine, especially when the business is running profitably. The bankers have 25% shareholding in the company. Therefore, any meaningful strategy for the growth of the business will be considered by them for further funding, if necessary. The growth in this industry, despite a general downturn in the economy as a whole, only helps facilitate the profits of serene Hall. Therefore, under better economic conditions, when the disposable income of the general public increases, the demand for the services provided by the company will improve substantially. The argument related to acquisition ‘that the effective cost of capital was zero since existing cash resources would be used’ underlines the fact that the company has ability to service the debts without any problem with the liquid resources available. The alternative strategies to closure of the business are very sound. The interest rate considered for our working is 10% for the other proposals. Since the normal hurdle rate is 8%, adoption of 10% can reassure the management about the profitability and debt servicing capacity of the enterprise. Areas of concern and critical issues In the case of acquisition, seamless integration of the two businesses is very important, as it may involve resentment among a section of the employees. However, there may be job/training opportunities if Serene Hall decides to adopt the increasingly popular Detox services provided by New You. It would be in the interest of Serene Hall to act quickly, as the market is already shuffling rumors of a New You - Old Hag Merger. If You New merges with Old Hag, that may give rise to a formidable competition to Serene Hall. Though the current liquidity position is comfortable for Serene Hall, mobilization of resources to fund acquisition at reasonable cost of capital is very important. A company needs to adopt acquisitions as a strategy for growth and increasing the market share. Inorganic growth strategy by way of acquisitions and mergers enable the companies to achieve these objectives quickly. Issue of equity shares, convertible debentures or debentures as purchase consideration, at least partly, to the promoters of New You is an option that could be considered for funding this acquisition. The proposal “Investment in upgrading Serene Hall facilities” is also very sound considering its superior returns at 5.37% p.a. compared to the proposal “Acquiring the assets of New You” at 3.94% as per Statement-II or 4.87% as per Statement-I. Evaluation of risks and its treatment is contingent upon various factors and, Pinches, G. E. (1982, p. 9) states “The proper treatment of risk is still a major source of concern”. Therefore, the company can’t strictly go by the decision based on return on investment alone. If the company opts out of acquiring New You, it may not be in a position to prevent the New You - Old Hag Merger. This development will not be in the best interest of Serene Hall. Myers, B. & Peters, J. (2006, p.16) state “The process of integrating two companies, whether it is termed a merger or an acquisition, must be treated with the urgency and focus applied to a turnaround situation”. Also, this eventuality could affect the estimated returns in respect of the proposal “Investment in upgrading Serene Hall facilities” as worked out in Statement-III in view of tougher competition. Recommendation and conclusion The demand for various facilities and services provided by the industry is partly linked to demographics. Lot of females are approaching mid-thirties would like to retain their mental and physical health/beauty by means of natural care, avoiding surgery. Also, the whole national culture seems to be taking on a positive approach to a healthy and relaxing lifestyle. In this background, the projections as per the Statement-1 or Statement-III are not only very conservative, but also attractive in terms of return on investment. According to Dixit, A. (1992, p. 107) “firms invest in projects that they expect to yield a return in excess of a required or ‘hurdle’ rate” (p. 107). We have adopted the rate at 10% which is in fact higher than the normal hurdle rate of 8%. Serene Hall is well placed to satisfy market demand more efficiently after acquisition. The strength of the management in this regard is confirmed by the track record of its performance and growth. Also, from the view point of stability, the size of the company matters. Gigerenzer, G. & Todd, P. M. (1999, p. 32) argue “each heuristic is specialized for certain classes of problems, which means that most of them are not applicable in a given situation” In the present case, as the market is expected to grow consistently over the next10 years, the company can follow inorganic growth strategy of “Acquiring the assets of New You” for its faster growth and market share as well as to fulfill its ambition to attain Plc status within the next few years. References Alberto, C. (2005). Investment decisions, net present value and bounded rationality, MRPA, Available at: Accessed on 2 Nov 2012. Cookson, I. (2006). The Board’s Role in M&A, Boardroom Briefing Fall 2006, Available at: Accessed on 2 Nov 2012. Dixit, A. (1992). Investment and hysteresis, Journal of Economic Perspectives, 6(1), 107–132, Winter. Demirakos, E. G., Strong, N. C. & Walker, M. (2004). What Valuation Models Do Analysts Use? ACCOUNTING HORIZONS, 18(4), December 2004, 221-240. differencebetween.net (2010), Difference Between NPV and DCF, Available at: Accessed on 2 Nov 2012. Gigerenzer, G. & Todd, P. M. (1999). Fast and Frugal Heuristics: The Adaptive Toolbox. In Simple Heuristics That Make Us Smart. See Gigerenzer, Todd, the ABC Research Group (1999). Khan, M. Y. & Jain, P. K. (2011). Financial Management, Tata Mc-Graw Hill, ISBN-13:978-07-106785-0. Myers, B. & Peters, J. (2006). The Board’s Role in M&A, Boardroom Briefing Fall 2006, Available at: Accessed on 2 Nov 2012. Pinches, G.E. (1982). Myopia, capital budgeting and decision making, Financial Management, 11(3), 6–19. Sheeba, K. (2011). Financial Management, Pearson, ISBN 978-81-317-3165-9. Suttle, R., (2012). Growth Strategies in Business, The Houston Chronicle, Available at: Accessed on 3 Nov 2012.hronicle Smith, H.T.J. & Moraitis, T. (2009). Serial Acquisition Options, Elsevier, Long Range Planning 43 (2010) 85-103. Appendices Statement - I Statement –III Investment in upgrading the existing facilities - Return on investment £ in m Interest rate 10% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Year->>> 0 1 2 3 4 5 6 7 8 9 10 Inflow Annual cash inflow 0.00 0.00 18.00 18.00 18.00 18.00 18.00 18.00 18.00 18.00 Present value factor 100% 91% 83% 75% 68% 62% 56% 51% 47% 42% 39% present value 0.00 0.00 13.52 12.29 11.18 10.16 9.24 8.40 7.63 6.94 PV of all in flows 79.36 Outflow Investment on upgradation 20 20 20 0 0 0 0 0 0 0 Present value factor 100% 91% 83% 75% 68% 62% 56% 51% 47% 42% 39% Present value 18 16.53 15.03 0.00 0.00 0.00 0.00 0.00 0.00 0.00 PV of all out flows 49.74 Net cash inflow 30 -18.18 -16.53 -1.50 12.29 11.18 10.16 9.24 8.40 7.63 6.94 Prov. for taxation @ 25% 0 0 0 3.07 2.79 2.54 2.31 2.10 1.91 1.73 Net cash inflow after tax 0.00 0.00 0.00 9.22 8.38 7.62 6.93 6.30 5.73 5.20 Present value factor 100% 91% 83% 75% 68% 62% 56% 51% 47% 42% 39% present value 0.00 0.00 0.00 6.30 5.20 4.30 3.55 2.94 2.43 2.01 PV of all in flows 26.73 Addl. Investments 49.74 Return on investment p.a. 5.37% Read More