Capital Budgeting Analysis For Saturn Petcare Essay And Critique Of Capital Structure For ARB Corporation.

Part A

Saturn Petcare Australia and New Zealand is Australia’s largest manufacturer of pet care products. Saturn have been part of the Australian and New Zealand pet care landscape since opening their first manufacturing facility in Albury Wodonga in 1966. Since then they have expanded their manufacturing footprint to include other sites in regional Australia and New Zealand including a world-leading manufacturing site opened in Bathurst, NSW in 2015. Saturn Petcare Australia New Zealand manufactures both for the domestic markets as well as exporting products to more than 26 countries. Saturn Petcare is part of the larger overall Saturn Group which is globally one of the largest privately held manufacturing companies and operates in a range of different fast moving consumer goods (FMCG) sectors including manufacturing well-known chocolate, confectionary, and food brands as well as pet food and pet care products.

Saturn have undertaken externally commissioned market research at a cost of $250,000 which has identified that a market exists for a new premium dog snack to be manufactured under their ‘Optimal’ premium pet food label. The Saturn marketing department have estimated that the new product will achieve sales of AUD$30 million in the first year and that sales will be expected to increase by 10% pa year on year for at least 10 years.

If Saturn proceed with this product launch a manufacturing production line must be constructed at an estimated cost of $27.5 million. To house the new production line Saturn have the opportunity to construct a purpose built facility alongside its existing dry food factory in Bathurst for a cost of $8 million. Alternatively, the production line could be built within an existing vacant factory space at the Wodonga head office site. When operational the new production facility is expected to create full time employment for an additional 20 staff. In addition you are advised that the Bathurst City Council has decided to offer as an incentive if the new facility is built in Bathurst a 100% rebate of the council municipal rate on Saturn’s Bathurst site (valued at $500,000 per year). In addition, the Bathurst City Council has negotiated a one-off regional infrastructure grant from the NSW state government of $2.5 million payable when construction of the facility commences. The existing factory space where the plant is planned to in Wodonga, Victoria is unused and there is no opportunity cost associated with it. It is expected that the production line plant and equipment will be depreciated on a straight line basis over its expected useful life of 10 years. The new building in Bathurst will have a useful life of 25 years and will be depreciated on a straight line basis. Saturn are an international company and pay Australian tax at the rate of 30% on profits. The capital budgeting analysis should be conducted on an after tax basis.

Nathan Quinlivan advises you that he is concerned about three issues:

1. That the possibility of product cannibalisation has not been considered;
2. Marketing estimates of year on year sales increases are high; and
3. He believes that the original $6 million cost of the vacant Wodonga factory space should be considered in the analysis.

For both the Bathurst and Wodonga production options calculate the following:

• After-tax cash flows 
• Payback periods 
• Net present values 
• Profitability index 

What recommendation would you make regarding the projects? Discuss any further information that you may require to help you make the accept/reject decision about either of these projects 

Define ‘product cannibalisation’ in capital budgeting decisions and address Nathan’s concerns that it should be considered .

Address Nathan’s concerns that Saturn’s marketing department’s budgeted sales estimates may be too high. What capital budgeting options are available to compensate for such an error? 

Address Nathan’s concerns that the original value of the vacant Wodonga factory should be included in the analysis .

ARB Corporation Limited designs, manufactures, distributes, and sells off road motor vehicle accessories and light metal engineering works in Australia, the United States, Thailand, the Middle East, and Europe. The company operates approximately 61 ARB stores in Australia. ARB Corporation Limited was founded in 1975 and is headquartered in Kilsyth, Australia. ARB is listed on the Australian Stock Exchange and reported total revenue for the 2017 financial year of almost $385 million.

As part of the finance team of ARB Corporation you have been tasked with reviewing and preparing a report on the capital structure of the firm and critique whether the firm has been successful in maximising wealth generation for shareholders.
Your report should be 1000 words and cover the following areas:

(i) Using data from the firm's 2017 financial year annual report and other sources assume that the firm ARB has a Beta of 0.89 (Reuters) and that capital return on the market for 2017 was 8.54%:

• Categorise the firm's current capital structure into debt and equity.
• Calculate the firm's after-tax Weighted Average Cost of Capital.
• Using the CAPM calculate whether the firm is providing an appropriate return given its risk

(ii) Compare the firm's capital structure with at least one other firm operating within a similar industry.

(iii)  Critically analyse other key financial ratios for ARB.

(iv)  Outline any significant changes to have occurred to the firm's capital structure during the past three years.

(v)  Critically evaluate the extent to which the firm has been successful in maximising wealth for shareholders in the past three years. In doing so discuss why it is important for the firm to minimise their cost of capital.

(vi)  Recommend possible ways in which the firm could adopt an alternative capital structure and lower their cost of capital.

Capital Budgeting for Bathurst Option:

The main purpose of the assignment is to analyze the business expansion options of Saturn Petcare which will be analysed on the basis of capital budgeting techniques applied by the business. The capital budgeting techniques involves computation of NPV of the options, payback period, profitability index on the basis of which analysis is to be conducted for the same. As per the analysis of both Bathurst and Wodonga production options, it can be said that Wodonga is the better option which the management of the company must select. The net present value of the Wodonga Site is $ 95,94,827 which is much more than Bathurst site which is $ 58,44,567. This shows that Wodonga site will prove to be more profitable for the business which is also confirmed by the profitability index of Wodonga site which is more than Bathurst site. The payback period of the site is also lesser in comparison with Bathurst site which shows that the company will be able to recover its investments earlier in case of Wodonga site. Therefore, it must be selected by the company.

Product Cannibalization is a strategy which is used in market in which the sales volume and sales revenue generated from one product is reduced so that another product can be introduced in the market (Kim, Chhajed & Liu, 2013). This is used by businesses when they want to introduce a new product in the market. The company is into the sales of pet care products and therefore there is a possibility that the company might use product cannibalization to introduce the new product in the market. The factor might indirectly affect the new product as the company will be using all resources for the new product sales maximization.

As per the belief of Nathan who is a director, the sales which is estimated by the marketing department is too high and it must be rectified as such would result in misrepresentation of the plans. The management can increase the cash outflows in the form of expenses so that the sales increase can be neutralized.

As per Nathan the original value of the property of Wodonga should be taken in the capital budgeting which is not correct. The new plant is to be built for the production of the new product and such will only be included in initial investments of the company. If the original cost of the property is included than the results will be unrealistic.

Introduction

This part of the assignment will be focusing on the performance of ARB corporation ltd which is to be done by analyzing the key financial ratios of the business and also an analysis is to be conducted on the capital structure of the company. The company is engaged in the manufacturing of road motor vehicles accessories.

The capital structure of the company reveals that the capital structure is made up of only equity share capital and there is no mix of debt capital in the capital structure of the business. The equity capital which is used by the business amounts to $ 2,72,341 which is all that is used by the business for financing the operations of the business (Robb & Robinson, 2014).

Part B

The beta of the company which is given is 0,89 and the market return comes to about 8.54%. The beta and the market rate of the business is used for the calculation of the cost of equity of the business in Capital Asset Pricing Model (CAPM).

The cost of equity which is calculated following general formula comes to about 18.05% which has reduced from the previous years estimate which was about 19.01%. As there is no debt capital which is used by the business therefore the cost of debt of the business is zero. On the basis of this the Weighted Average Cost of Capital (WACC) is computed for the company considering the tax rate applicable. The WACC of the company is same as the cost of equity of the business as there is no cost of debt for the business. The cost of equity which is computed under CAPM method comes to 7.906% which shows that the company is living up to the expectation of the shareholders of the company as the market return rate is more than the expected cost of capital under CAPM method but the same can be further improved (Frank & Shen, 2016).

A change in the capital structure of the business can be seen from the previous year figure. In 2016, the capital structure of the company comprises of equity capital which amounted to $ 2,49,608,000 which has increased in 2017 and the figure amounts to $ 2,72,341,000. The analysis also show that the company had used debt capital in 2015 which amounted to $ 2000,000. The higher rate of WACC of a company signifies that the risks associated with the business is high and the shareholders will be expecting similar returns for the risks which is bear by them (Öztekin, 2015).

Modine ltd is a manufacturing concern which belongs to the same industry as ABR ltd. Modine ltd’s capital structure is made up of equity which is $ 421.20 million and the company also has debt capital which amounts to $ 510.90 million. Hence it can be said that the business is making use of the capital structure to minimize the risks of the business. In case of ABR ltd, equity capital is only used in the capital structure of the company. it can be said that the capital structure of Modine ltd is more balanced and favorable.

The shareholders wealth statement which is given below shows that the company has not been able to achieve growth and the company is unable to fulfill the company’s objective of wealth maximization. The main reason for this is because of the company’s reliance on equity funds which solely forms part of the capital structure of the business. The management needs to mix debt capital to the capital structure so that shareholders wealth can be maximized. In addition to this, the NOPAT of company has increased from the previous year figure which is $ 47,439 and has increased to $ 49,152. Even though the NOPAT figure has increased from the previous year’s figures however, if the business wants to improve the same more and attain more growth than the capital structure of the business needs to be improved. The business needs to attain a mix which is the optimal capital structure and which can help the business gain more profits.

Conclusion

Thus, from the analysis of the capital structure of ABR ltd it can be said that in order to balance and improve the capital structure of the business, the company needs to find the favorable mix which will make a perfect capital structure for the business. The company has increased equity portion in the capital structure in 2017. In addition to this, the company needs to improve the WACC of the company which can be achieved by improving the capital structure of the business that is introducing debt capital into the mix so that a favorable WACC of the company can bee obtained.

References

Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of Financial Economics, 119(2), 300-315.

Kim, K., Chhajed, D., & Liu, Y. (2013). Can commonality relieve cannibalization in product line design?. Marketing Science, 32(3), 510-521.

Öztekin, Ö. (2015). Capital structure decisions around the world: which factors are reliably important?. Journal of Financial and Quantitative Analysis, 50(3), 301-323.

Robb, A. M., & Robinson, D. T. (2014). The capital structure decisions of new firms. The Review of Financial Studies, 27(1), 153-179.