Growth Plan for ABC Company - Case Study Example

Project Decision Making School Project decision making Introduction This report has been formulated in response to an inquiry aboutthe cash flows of the ABC Company, its option of starting a new project and decision making about the purchase of equipment needed for providing ease in the production of the new proposed product. Risks to the company The company may face some industry as well as economic issues. These issues may include introduction of cheaper and better alternatives which may hinder the demand for the company’s products and services to a great extent. Another significant factor may be the financing of its projects and future productions. This factor will depend on the financial position, income and cash flows of the company. Investors are attracted only if the aforesaid statistics are satisfactory. 1. (a) Statement of cash flows 2. (b) i Sources and uses of the company funds The main source of the cash inflow as evident from the cash flow statements is the amount of cash received from the sale of goods and services. The main sources of use of the company’s funds as evident from the cash flow statement are: (i) cash paid to suppliers and creditors in respect of different material purchased (ii) Cash paid on account of operating expenses of the company (iii) amount of cash paid for the acquisition of equipment and (iv) amount paid to shareholders in respect of dividend paid to them. 2. (b) ii Measures to improve cash flows Company may improve its cash flows by initiating a policy of discounts allowed to debtors for prompt payment. Policy must include clear guidelines that who pays the debt of the company as early as possible; they will be given some discount. This policy will help the company to receive cash from the debtors on a recurrent and fast intervals and thus increasing the incoming cash flows of the company. The company can also improve their cash flows by purchasing materials from those suppliers and creditors who allow a more credit period (in respect of days) so the company will have to pay less amount of cash for a particular period thus improving its cash flows. 2. (b) iii Financing the project through current cash flow The company cannot finance the future projects keeping in view the current cash flow as its net cash flow is unfavorable. The company must first focus on the improvement of its cash flow and once their future cash flows are improved then company may finance the projects through those cash flows. 2. (b) iv Equity or Corporate debt In my opinion, Company may opt for the option of acquiring Equity debt as it will result in less amount of dividend/interest to be paid to the shareholders. If the company opts for a bank loan or corporate debt, then it will have to pay higher interest rates on that and as the cash flow of the company are already unfavorable so it will not be a good option for the company. 3. (a) Product cost under Variable/Marginal Costing Method: Material (5.6*5000) 28000 Labor (4*5000) 20000 Variable factory Overheads (1*5000) 5000 Total variable cost 53000 Fixed factory overheads (198000/45000*5000) 22000 Total product cost 75000 Product cost under Absorption Cost Method: Material (5.6*5000) 28000 Labor (4*5000) 20000 Variable factory Overheads (1*5000) 5000 Total variable cost 53000 Fixed factory overheads (198000/45000*5000) 22000 Selling expenses (191250/45000*5000) 21250 Total product cost 96250 3. (b) Fixed factory expenses absorbed by the new product’s expansion: Per unit Fixed overheads with the existing product (198000/40000) $4.95 Less: Per unit fixed overheads after the introduction of new product (198000/45000) $-4.4 Decrease in per unit of fixed factory overheads (existing) $0.55 Fixed factory overheads absorbed by the new product (40000*(4.95-4.4)) 22000 Net decrease in existing selling overheads by the introduction of new product: Selling overheads with the existing product (191250/80000) 2.39063 Less: Selling overheads after the introduction of the new product (191250/85000) -2.25 Decrease in per unit of fixed factory overheads (existing) 0.14063 Selling overheads absorbed by the new product 5000*0.140625 703.125 3. (c) Selling price of the expansion product when gross profit margin is 40% Selling price = Cost of goods sold + gross profit (Ittelson, 2009, p. 67) OR S = C+GP S = 87250 (Exhibit 1) + 40% of S S – 40% of S = 87250 S (1-0.4) =87250 S = 87250/0.6 S = $145417 3. (d) Contribution Margins and Break-even Points The contribution margins and Break-even points for both the stages of the production are as follows: Existing product New product Contribution Margins 736000 91417 Break-even Sales 577480 145417 Exhibit 2 shows all the calculations for the above statistics. 4. (a) The net present value of the investment proposed to be made is calculated below which shows that the value is $1,366 negative. Calculation of NPV and IRR for the given project Year Cash flow 0 ($42,000) 1 $15,000 Interest rate 12% 2 $13,000 3 $10,000 4 $10,000 5 $6,000 Net present value ($1,366) Internal Rate of return 10% 4. (b) Impact of 5-years straight-line depreciation on fixed factory costs and cash flows (for each of 5 years) The depreciation charged on the equipment will result in increase in factory costs for each of the five years by an equal proportion. Keeping in mind the cash flows, the purchase of the equipment will increase cash inflows by the net of purchase price less depreciation charge for the first year, while, for the next four years, the depreciation will result in positive cash flows being a non-cash item decreasing income of the company. 4. (c) Recommendation for the purchase or non-purchase of the equipment Having a glance at the Net Present Value (NPV) and Internal Rate of Return (IRR) as calculated for the equipment, it is not recommended for the company to purchase the equipment as both these are unfavorable for making the decision to purchase the equipment. Of the NPV and IRR, only NPV is sufficient to decide not to invest in a project if the NPV is negative even with good IRR result (Yescombe, 2013, p. 39). Here both these are unfavorable and, hence, it is strictly not recommended to the company to invest in the equipment. Negative NPV signifies that the future cash inflows are not sufficient to cover present investment (Erickson, 2014, p. 24). 5. (a) Major risk in the project A very serious risk in the project is that almost all the statistics do not show an evidence to prove that the project will benefit in the future. The company, investing in the project may become capable of achieving its growth targets of $3 million for the next three years but it is certain that the company will have to bear a significant decrease in the profits. The reason behind this can be explained as the company is already going towards negative cash flows. It means that there are no cash funds available to the company to finance the project by its own; therefore it will have to depend on loans either in the shape of corporate debt or issuing equity instruments. The former will result in having finance costs while in return to the later, the company will have to pay dividends both further reducing the profits and cash flows. 5. (b) My responsibility Being the controller and management accountant of the company, I hold myself responsible in regards to this project for identifying and ensuring any possible reduction in the finance costs and other costs related to the project. Further, I would recommend any possible reduction in wastage during the production of the units in this project to make it worthwhile. 5. (c) I recommend to the CEO to think of some other alternative for achieving the target set by the company. The reason is that, although this project may have success in achieving the targets, but it will make the company suffer a lot in regards cash flows, finance costs and the net incomes. Exhibit 1 Cost of Goods Sold Statement Amounts in $ Direct Material 28000 Direct Labor 20000 Variable Overheads 5000 Selling expenses (0.2*5000) 1000 Contribution 54000 Fixed factory overheads 22000 Fixed selling overheads 11250 Total cost of goods sold 87250 Exhibit 2 Contribution margins and Break-even points for both the stages All amounts in $ Existing product New product Sales 1160000 145417 Total variable costs -424000 -54000 Contribution 736000 91417 Fixed costs -366353 -33250 Profit 369,647 58167 Break even sales = Fixed cost/Contribution ratio (All amounts in $) AND Contribution ratio = Contribution/sales For existing product Break even sales = 366647/(736000/1160000) Break even sales = 577,480 For new product Break even sales = 33250/(91417/145417) Break even sales = 52887 References Erickson K. H., (2014) Investment Appraisal: A Simple Introduction CreateSpace Independent Publishing Platform. Yescombe E. R., (2013) Principles of Project Finance, Second Edition Academic Press; 2 edition. Ittelson T. R., (2009) Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports. Career Pr Inc; Rev Exp edition . Read More