Pound by Pound (PP) has been progressive since it begun. A new plant to be used for food processing and additional production of herbal supplements may enable the company to further its growth. This memo addresses feasibility of expansion through analysis of capital asset purchases, sales, income, cash flows, value and other project risks, without considering financial alternatives at this point in time.
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Under current operations, sales are expected to increase by 10% with net earnings of $48,000; a 45% increase from 2009. Management senses that by expanding, sales will increase by 40% within one year and 12% in subsequent years. Earnings results would vary, depending on the type of financial support. A comparison of current and projected performance indicates that current financial results are slightly below industrial level. Expansion and introduction of a new line would narrow the gross margin by 2%, 52% in comparison to industry’s 54%, however, net earnings would remain below industry.
Forecast on expansion results indicate increased sales, income, capital asset base, and cash flows while decreased cost of goods sold (COGS) and earnings per share (EPS). This is based on 10% of cost of capital rate and a NPV of $133,000.00. The sales projections to capital budgeting analysis indicate that this is a viable plan. Results are:
- Net Present Value: $133,000
- Internal Rate of Return: 12%
- Profitability Index: 1.12
Before accepting these results, I assessed the plan using various sales projections. Results indicate that, if first year sales are less than 40%, the project is not feasible. Analysis also indicates that the project feasibility is highly sensitive to achievement of sales targets and cost of capital not exceeding 10%.
Additional concern should focus on increased sales projections and decreased COGS with respect to value of the share holder. In general, stakeholders will not perceive expansion positively if the firm’s value is represented in a decreased EPS and COGS, since it calls for control of operating costs. High sales target may also cause management to impose harsh unethical or illegal requirements on staff, to meet sales quotas particularly if bank covenants are involved.
The Canadian industry benchmark sales’ figures average at 3% yet PP’s projections are much stronger at a 40% increase with an annual raise of 12%. Industry averages are based on two different business models and may not accurately reflect PP’s potential growth after expansion. One business model holds 85% of the market consisting of two large Canadian firms, whose parent company is in the USA. The other business model consists of markets that holds 15% of the whole and distributes exclusively through their own facilities.
Being a local Canadian company distributing through ten retail locations in Greater Winnipeg area, PP does not compare neatly to industry benchmarks. Focusing on a small regional market may complicate achievement of sales projections. To increase sales, consideration of the current geographical location ought to be in light of competitive strengths. Decision over market occupation is necessary and may be addressed through the following questions:
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- Can sales increase in the existing market, or is it already controlled and saturated?
- Does PP currently control this market, if not, how will it take over?
- Will the market satisfy sales projections, if not what will be PP’s new market?
When entering a new sales area, such as ready-made meals, there is always the risk of customer response. Sales increase will depend on new offers from the company such as regular PP menu items that customers will consistently purchase. Based on this information, it may be difficult for PP to succeed in this market unless customer demands are within the current market niche. Conducting a market survey and analysis would help address the uncertainties regarding expansion and sales projections.
Proposed expansion will increase capital assets from slightly over $1 million to excess of $2.4 million. It will require an initial outlay of $1.4 million and increased working capital. Initially these actions will have a negative effect on net income and net cash flows, yet as the project matures positive results favour feasibility.
Increase of assets on the balance sheet depends on Investment in capital assets. Liabilities or shareholder’s equity will also increase, depending on the form of financing. Furthermore, increased capital asset base will increase annual amortization expense resulting to decrease of net income; yet for financial reporting this will be added back and the increased Capital Cost Allowance (CCA) will be expensed. There will be a tax savings through the CCA tax shield due to reduction in tax liability. These are positive results favouring feasibility. In addition to amortization expense, additional sales and administrative expenses will also be realized. To ensure viability of capital purchase, incremental gross margin needs to be greater than the additional expenses.
The expansion will significantly change current operations. Additional staff will run production line. Adequate inventory management systems and warehousing facilities will need to be implemented to accommodate raw materials and inventories of finished goods. Sensitivity over shelf life ought to be addressed to minimize obsolete inventory. Appropriate health standards and regulations will ensure proper food handling, packaging, and storage.
Adding the new product line has increased inherent risks to the shareholders, investors, creditors and employees. PP’s rapid growth would require additional management expertise and human resources. This would increase risk due to growth logistics. Nevertheless, PP would also be diversifying risk due to increased product diversification. There is need to minimize current quality control issues as a measures to mitigate increased risk while expanding. The company’s competitive advantage would be maintained and strengthened by minimizing risk through quality control procedures such as prevention and appraisal of processes to minimize misuse of resources.
Feasibility for expansion plan is based on net operating cash flows that increase annually according to the NPV. However, increased profits mean increase of taxes.
Expansion plans result to a net increase of cash flows, partly due to the nominal inflation rate of 2%. It appears that variable costs increase in line with sales. With increased cash flows, management of working capital could focus on either debt reduction or investment. In the long run this may mean redeeming shares or further expanding operations. The increase in cash flows promotes feasibility for expansion plan.
The positive NPV and increasing annually net cash flows leads to additional of value to PP. However, when determining added value the impact on Earnings per Share (EPS) must be considered. In 2010 budget EPS increased by 0.016 from 2009; nevertheless, with expansion, EPS decreases translating to low shareholder’s value. The decrease is due to increased debt or equity which negatively impact on EPS. The decrease may be short-term, with a long-term increase depending on the chosen financing alternative. Overall long term value may be increased for the firm which would favour feasibility. This should be made clear and reported to all stakeholders.
Initial analysis of the expansion indicates that the project could be a viable way to promote growth. However, closer analysis indicates existence of many evaded risks. Before proceeding with the plan, I recommend a more detailed analysis to be completed with more information gathered as follows:
- Survey existing customer base to determine demand for ready-made foods. This will provide a better understanding of expected sales and will support sales projections.
- Investigate input costs of producing prepared foods, determine shelf life product, and understand regulatory requirements that must be met to ensure all relevant costs have been taken into consideration.
- Evaluate company strategy, goals, and objectives to determine if capital expansion is the most feasible method for growing the company at this time.
- Minimize current quality control issues to increase current sales and decrease disposal costs.
I would be willing to meet with the board to review my findings in details and work with the management to gather additional information, to ensure that a detailed assessment of this expansion plan is completed.