Lucy’s Diamonds Ltd (LDL) is a diamond jewellery business located south of Sydney in the southern highlands. The business was started by Lucy Sky in the late 1970’s and is now run by Lucy and her partner Ben Pepper. Lucy and Ben each own 40% of the issued ordinary shares in the company with the balance owned by Lucy’s family. The company’s Board of Directors consists of Lucy, who is Managing Director, Ben and Martha Sergeant (Lucy’s sister) who is the company secretary. Martha works in the business as the Accountant/Office Manager and has recently completed a Master of Finance at UTS.
The business has been through some difficult times in recent years mainly due to the fashion for diamonds for engagement rings falling. They have survived by expanding their business to include items other than jewellery which include belts and hair accessories. On top of this they have built up a good reputation for high quality craftsmanship and diamonds.
The company operates from premises in Bowral that it has owned since the business was incorporated. They are currently renting extra space in Burradoo to produce the new lines of belts and hair accessories. The rent for this premises is $10,400 p.a.. They are considering consolidating their two premises into one larger one which would require them to sell their current one in Bowral, cancel the lease on Burradoo and buy new premises in nearby Renwick. The cost to cancel the lease early will be a tax deductible $2,000. The maintenance costs are likely to increase, currently they are paying $2,600 p.a. and expect this to rise to $3,400 (in the first year) p.a.. It is anticipated that these will increase by around 2% p.a. over the next five years, as shown in Appendix 1 (2% increase already included in these estimates).
Lucy and Ben have asked Martha to investigate the feasibility of expanding the business more permanently into the new premises. Lucy and Ben have just completed an overseas trip (a combination of work and holiday) during which they completed some research into the latest production equipment used in Europe. The trip was very expensive and it cost $37,500 for airfares, accommodation and meals. As most of the trip was business the company has paid for the work related expenses of $17,500. On returning from the trip Lucy and Ben met with Martha to outline what they have learnt.
They believe with new production equipment they could expand their operations even further to include evening bags and purses. Moving to the new proposed premises in Renwick would enable them to do this expansion more easily than their current spread over two premises and towns.
They firmly believe that LDL would be able to take on this expansion without affecting the high quality products currently provided to the existing clients. Lucy tabled a projected revenue forecast for the expansion. The forecast revenue is detailed in Appendix 1. She also outlined some preliminary estimates on the costs involved. The new premises would cost about $1,160,000 to purchase. Another large cost would be the new equipment they wish to purchase to expand their range. They had a firm quote from the German company and the total cost including all shipping, installation and testing would be $475,000.
Lucy was very excited and said they would like to see the company at least double its revenue in the next three years. Martha argued that the company was profitable and provided a good return at the moment and a larger company may bring more problems. She felt that Lucy and Ben had not considered the extra staff that would be needed to work in the new premises. It was anticipated that three new staff would be required and that all the staff, new and the existing 5, would require training on the new equipment. This training would cost $10,000 per staff member and would have to be undertaken before the equipment could be implemented. The new staff would be paid $65,000 p.a. each. It was also agreed that an allowance would be made in the analysis for all wages to increase by 3% p.a.. Details of the other agreed changes in wage costs are shown in Appendix 1 (3% increase is already included in these estimates).
The current premises is quite valuable and a local company has recently offered $735,000 for it. Martha firmly believed that this is an extremely good offer and if they decide to move they should accept it. Ben was a bit restrained and stated his concern was the level of investment required and raising the cash. The company certainly did not have any spare cash. The company had borrowed the amount required for the last renovations and were still making payments on the term loan from the bank. In the current climate he was concerned that additional finance of that magnitude would be difficult to obtain from the bank. He felt that a proper business plan should be produced and a short report prepared for all board members and the full Board should make the final decision. Lucy emphasised that Martha had the skills to assemble all the data required and write a report and that they should meet in about a week to make the decision whether to move and make the expansion or not. A summary of the data presented at the meeting and any relevant discussion is shown below:
1. It was agreed that the sales figures presented by Lucy as shown in Appendix 1 would be used in the analysis.
2. The quote for the German equipment had been confirmed in writing. The tax office had confirmed that the $10,000 per staff member for training would be a tax deduction at the time the amount was paid although Martha said the company did have the opportunity of spreading this cost and about 20% of the cost of Lucy and Ben’s overseas trip over ten years for accounting purposes.
3. Martha has told Lucy that there is old equipment held in the current premises that could be used in the new one. Although several years old they are fully depreciated and the new project could have them at no cost. The equipment had recently been appraised for insurance purposes and had a market value of $10,000.
4. Martha has analysed the cash flows and the company would have to borrow $900,000 to finance the project. The bank has given preliminary approval but want to see a final business plan. The interest rate would be 5.25% p.a. compounding monthly and the loan will be repayable over 7 years with a monthly repayment of $12,826.51.
5. The company pays tax at a corporate tax rate of 30%.
6. Martha’s believes that the current weighted average cost of capital for the firm of 15% is appropriate to use to evaluate the new project as it is in the same risk level as their current business operations. Inflation is already included in all revenues and expenses forecasts.
7. Land is not depreciable and no capital gains tax will apply. In five years it is estimated that the new premises could be sold for about $1,160,000. The tax office has determined that the building valued at $700,000, can be depreciated at 7% p.a. straight line based on cost and the equipment at 20% p.a. straight line.
8. In five year’s time the new equipment would only have a scrap value of $120,000 while the old reused equipment would have no value.
9. There would be an increase in inventory of common spare parts estimated to be 10% of the following years’ revenue.
You have been asked to assist Martha and are required to submit the following;
- An executive summary making a recommendation to Lucy’s Diamonds Ltd whether to expand or not to expand the business as outlined. The executive summary# must contain concise reasons for your recommendation and a summary of your financial analysis. The executive summary should be a maximum of two A4 pages (single space 12 font). ( 5 marks)
- Readable spread sheets## clearly showing the NPV of the project and all other calculations that are used to support your decisions. (15 marks)
Case studies may be handed in at your seminar during the week commencing 4 May, 2015 or drop off at Level 1 (street entry) Block C of Building 5. It is located on the SIDE of the Student Centre (along the corridor) and NOT over the counter by 5pm Friday 8 May, 2015. Please ensure that completed cover sheet is attached to your assignment and that only one case study per group should to be handed in. Any questions regarding the case study should be posted on the Case Study Forum of the Discussion Board on the UTS Online site.