Analysis And Recommendations For SoCal Limited's Marketing Campaign Strategy And Equipment Purchase Essay.

SoCal is a manufacturer of suitcases that operates in Los Angeles since 1984. The company has been facing a few issues that you - the chief financial officer - will have to act on as requested by the Board of Directors (BoD). Most prominently, SoCal's revenues have substantially decreased, with the demand for its suitcases at levels not seen since 2010. To overcome the obstacles entailed by such situation, the marketing department has suggested to launch an aggressive campaign whereby the payment period to wholesale customers is extended from 20 to 40 days, leading to (forecasted) sales of 12,500 suitcases per year (based on a unitary price of $90 per suitcase). Regardless of prolonging its accounts receivable period, the company would still be liable to pay its suppliers in 15 days, with production levels of 50 suitcases per day.

To accommodate the increase in demand (and considering that suitcases stay in stock for a period of 30 days), SoCal would need to buy new machines costing $1,200,000, with a lifetime of 6 years.

Moreover, the marketing campaign will involve a cash cost of $400,000 per year. Variable costs associated with the production of suitcases would remain the same ($50 per suitcase paid to suppliers). During their lifetime, the new machines will be able to generate free cash flows in the amount of $675,000 per year, having 'zero' salvage value by the time they need to be replaced.

To implement the strategy suggested by its marketing department, SoCal can dispose of assets in its balance-sheet, or else borrow money in the financial markets. Particularly, the company has (i) 1,500 units of Australian government bonds ($1,000 face value, 10 years to maturity, annual coupons of

$40 and yield to maturity of 5% per year), and (ii) 130,000 ordinary shares of XYZ (a public listed company whose last paid dividend was $0.50 per share, with growth prospects of 5% per year and exposure to market risk i.e. beta of 1.2). Based on its balance-sheet (80% debt, 20% equity), SoCal can borrow funds paying an interest rate of 20% per annum (the tax-shield in the U.S. is 30%), whereas its cost of equity is equal to that of XYZ (assume an annual rate return on the market portfolio of 9%, and a risk-free rate of 2% per year).

Based on the background provided in the case study, you are to write a report addressing the following key questions:

1. In terms of working capital requirements, what are the implications of increasing the payment period (or average collection period) from 20 to 40 days? Please refer to the operating and cash conversion cycles in your answer.
2. Based on the forecasted sales, is it possible for SoCal to achieve the corresponding cash and accounting break-even points? Based on your calculations for each - and from a pure cost management perspective - is the marketing department's proposal acceptable? Explain.
3. Use the net-present value criteria to assess whether the investment in the new machines is warranted (Hint: use SoCal's cost of capital as its discount rate). Explain to the BoD the benefits of the NPV vis-a-vis other capital budgeting methodologies.
4. If the market price of 10 years Australian government bonds is currently at $850 per unit, whereas the stock of XYZ is being negotiated in the market for $10 per share, which asset SoCal should sell to raise the necessary funds? Explain the reasons behind your decision.
5. Based on the answers to the previous questions, determine whether to endorse the plan suggested by the marketing department to the BoD.

Marketing Campaign Strategy Proposal

The report provides an analysis of the suggestion given by the marketing department of SoCal Limited, which includes introducing an aggressive marketing campaign and also increasing the credit period allowed to the wholesale customers from 20 to 40 days.

In order to cater to the increased demand of products, the company would have to purchase a machinery, with a useful life of 6 years and a zero salvage value at the end of its useful life.

The company has two alternatives to finance the purchase of machine as well as the marketing campaign, i.e. to borrow the money from outside or to sell the assets to arrange money, if the company decides to sell the assets, it has two options:

1. 1,500 units of Australian government bonds
2. 130,000 shares of XYZ Company

The report analyses various aspects and gives an ultimate advice to the management as to whether or not it should accept the proposal given by Marketing team.

Working capital requirements

The marketing team has also suggested to increase the credit period of wholesale customers from 20 to 40 days, which will have an incremental working capital requirement. Since the credit period of the customers will increase by 20 days, the working capital requirement will increase by an amount equivalent to 20 days sale made by the company in a year.

The operating cycle of the company, will increase, since operating cycle is a measure of time taken by the company from the period the cash is put in to the operations till the time, the inventory is converted back into cash. Operating cycle is widely used ratio, to assess the time taken by the company, to complete a cycle from purchase of raw material to the collection of receivables (John C Groth, 1992).

There is a similar parameter, which is Cash conversion cycle, this is a subset of operating cycle, as it measures the time that it would take, for the company to convert the inventory to cash.

Inventory conversion period is another similar parameter, which is a smaller subset of cash conversion cycle, it deals only with the time period taken to convert inventory to sales. And the amount of time taken by the customers to pay off for the sales, is known as deferral period.

Collection period refers to the time that it takes for the company, to collect its accounts receivable. Thus, in this case, the existing collection period of SoCal is 20 days, which is now proposed to be increased to 40 days.

Equipment Purchase Proposal

In the given scenario, the working capital would increase by an amount equivalent to 20 days sales for the year, on an average, i.e. 20% of $ 1,125,000, i.e. $ 62,500.

Thus, the company would require $ 62,500 to meet the additional working capital requirement.

Break-even occurs, when the company reaches the level of sales, it is able to earn sufficient contribution margin, so as to cover its fixed costs obligations. Contribution margin refers to the difference between the selling price and the variable cost incurred on the product, it is the amount earned by the company, on sale of product, without considering any fixed cost obligation of the Company.

Break-even level is critical as before a company becomes profitable only after it has been able to cover all its fixed costs.

Calculation for break-even point is different in accounting terms than what it is in cash terms, i.e. in management accounting terms.

Key differences between the two arises, due to non-cash expenses, such as depreciation, provisions, etc. As the financial accounting takes into consideration all the non-cash expenses, such as depreciation and also considers the expenses on accrual basis, whereas, on the contrary, cash based break-even, as the name suggests, is calculated on the basis of the cash receipts and payments linked to the product.

The computation for breakeven points based on accounting methodology is provided in Appendix-1. Based on given levels of sales, i.e. 12,500 unit per year, the company will not be able to breakeven for the 6 years, based on the accounting method, as the interest and depreciation cost is significantly high and in order to cover that cost, the company needs to earn a higher contribution margin, for which it needs to increase its revenue from sales, over the period.

Appendix-2 provides the computation of break even point based on cash method. Which is based on the given information about the free cash flow that the machine would provide over its useful life, i.e. $ 675,000.

Free cash flow refers to the amount of cash flow generated from the operations of the company, after taking into consideration the amount required for upkeep and maintenance of fixed assets of the company. Thus, in this case the free cash flow can be assumed to cover the depreciation cost of the machine, but the marketing campaign cost and the interest cost has been considered separately.

Thus, based on the computation made in appendix 2, the company is operating at a level higher than the break-even level. Thus, based on cash break-even point, the management should accept the marketing team’s proposal.

Working Capital and Operational Cycle Analysis

In evaluation of a capital investment project, the management can use various tools of capital budgeting including but not limited to Net present value, Internal rate of return, payback period, discounted payback period, etc.

The most commonly used and widely accepted tool is Net present value, which computes the cash flows over the life of the project and discounts them at the cost of capital of the company, to arrive at the present value of the cash flows that would be generated from the project and then a comparison is made between the cash inflows so generated and the cash outflow on the project, to arrive at a decision, whether or not to invest in the project (Ondrej Zizlavsky, 2014).

As explained above, for calculation of NPV, we require:

1. Cash flows over the life of the project
2. Cost of capital: This is the cost that the company incurs for using the capital, it is a multiple of various costs, such as cost of debt, cost of equity, etc. Computed as a proportion of various sources of funds used by the company.

For the given case, the NPV is computed in Appendix-3, which provides that the company would be able to generate a positive cash flow of $ 840.689 over the lifetime of the project, thus, it is advisable for the company to accept the proposal of the marketing team and go ahead with the investment in equipment and spending on the marketing campaign.

The company was initially planning either to borrow the funds or to arrange the funds through the sale of assets held by the company, which are, Australian government bonds and the share of XYZ Company.

As per the given information, company has decided to sell the assets to arrange funds but the question that now remains, is which of the assets should the company sell, and this would depend on the comparison between the cost price and the market value of the asset. The company would be interested in selling an asset that has a market value higher than the cost of the asset for the company and vice versa.

Thus, computation of market value for both the assets is given in Appendix -4 (Augusto Castillo, 2004). Based on the computation provided in the appendix, the market value of share of XYZ company is higher than the derived value and thus, it is advisable for the company to sell the shares of XYZ company limited, in the required quantity to arrange the funds for the project. In case the company would have gone for the sale of bonds, it would have sold an asset at a value lower than the purchase price of the asset, causing a loss to the entity.

Break-Even Analysis

The decision on whether or not to accept a project, is dependent on the cash flows that the project is expected to generate over its lifetime. Generally, the projects with positive cashflows are accepted and the projects with negative cash flows are rejected.

In the given case, though, the accounting breakeven analysis of the project depicts that the project will not be able to achieve break even, the project is expected to generate a positive cash flows over its useful life and thus, it is advisable for the management to accept the proposal given by the marketing team, based on financial analysis.

In addition to the financial feasibility, which is an important deciding factor for the capital investment decisions, the management should also take in to consideration various other factors, which are not financial but are relevant to be considered before decision making, such as:

1. Expected action by competitor:

If the company will launch an aggressive marketing campaign, the competitors of the company would also launch a counter campaign to promote their product, which in turn would lead to a decline in sales of the company’s product. The company, thus, should consider the expected reaction by the competitor.

1. Changing preferences of the customers:

The capital budgeting analysis is based on the expected level of turnover that the company would be able to achieve over its useful life, it is based on certain assumptions in relation to the demand for the project, by a category of customers. The shift in preferences of the customer due to increasing disposable income or any other reasons, could lead to a significant deviation in the actual sales, vis-à-vis the expected sales (Abduaallah Al-Mutairi, 2018).

Thus, non-financial factors should also be analyzed by the management, before accepting the proposal.

Conclusion and recommendation:

Based on the financial analysis, the management should accept the proposal presented by the marketing team, whereas, it is recommended that management must perform an analysis of the non-financial factors linked to the project, before arriving at a final decision.

If based on the evaluation of various non-financial factors, which are expected to affect the cash flows from the project, and testing various assumptions, that management has made, while estimating the cash flows from the project, the management concludes that the project would be financially viable, management should go ahead and accept the proposal of the marketing team.

The recommendation would be to thoroughly test the assumptions made in relation to the cash flows from the project and perform the sensitivity analysis based on the expected changes in the estimated cash flows over the life of the project, in order to be aware of the scenario, which could change the outcome of the project.

References:

Abduallah Al-Mutairi, Kamal Naser and Muna Saied. (April, 2018). Retrieved from https://www.tandfonline.com/doi/full/10.1080/23322039.2018.1468232. Viewed on 12 October, 2019.  

Ondrej Zizlavsky (April, 2014). Net present value approach: method for economic assessment of innovation projects. Retrieved from https://pdfs.semanticscholar.org/0f14/1a93f6a724f901ff7d581d238b1483d31177.pdf. Viewed on 11 October, 2019.

John C Growth, (April, 1992). The Operating Cycle: Risk, Return and Opportunities. Retrieved from https://www.researchgate.net/publication/247617637_The_Operating_Cycle_Risk_Return_and_Opportunities. Viewed on 12 October, 2019.

Surendranath Rakesh Jory (2016). Net Present Value Analysis and the Wealth creation process: A case illustration. Retrieved from

www.aejournal.com › ojs › index.php › aej › article › download. Viewed on 11 October, 2019

Augusto Castillo, (2004). Firm and corporate bond valuation: a simulation dynamic programming approach. Retrieved from https://pdfs.semanticscholar.org/52cd/905c159fd3050a72df5b18d9bafb98edc169.pdf. Viewed on 12 October, 2019.

Frida Pacho, 2014. Capital Asset Pricing Model (CAPM) Testability and its Validity in Stock Market: Evidence from Previous Literatures. Retrieved from https://pdfs.semanticscholar.org/d048/8256fc00aa25fc0e1c227c152e15b0fba555.pdf. Viewed on 12 October, 2019.