Capital Budgeting And Capital Structure Analysis Essay.

Saturn Petcare Australia and New Zealand

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.

Capital Budgeting Analysis

You have been asked by Nathan Quinlivan the Demand and Strategy Finance director for Saturn Petcare Australia New Zealand to conduct a capital budgeting analysis of the two options. Saturn have a global target return on investment of 22% pa. Margin after Conversion (MAC) for this new product is budgeted at 30% of gross sales. 

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 

Required: 

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 . 

Part B Report

Guidelines:

For this assignment, you are encouraged to use the information provided on the firm's corporate websites together with the following sources:

• OneSource: Global Business Browser (available through Library Databases:
• Australian Stock Exchange http://www.asx.com.au/
• Yahoo Finance https://au.finance.yahoo.com/
• Reuters http://www.reuters.com/finance/markets
• News sources such as those secured through the Library's ANZ Newsstream and Factiva databases are also likely to be relevant

Your report should include:

• A brief executive
• Introduction.
• Body (use appropriate headings and sub-headings as relevant sign-posts).
• Conclusion 

Required: 

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 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. 

Rationale

This assessment task covers Topics 6 through 10. This will provide an opportunity to apply the concepts in an authentic scenario that you may encounter in the workplace and also:

• be able to evaluate and explain the congruence of accounting, finance and treasury functions
• be able to demonstrate appropriate communication skills in the context of corporate finance.
• be able to demonstrate specific technical competencies and skills in utilising quantitative techniques in financial analysis.

Saturn Petcare Australia and New Zealand

Executive Summary

The assignment is based on two separate tasks which focuses on two different companies which are Saturn Pet care ltd which is engaged in manufacturing of pet products and ARB Ltd which is engaged in manufacturing activities of road motors accessories. In the first task capital budgeting technique will be applied so as to select from two different production site which are Bathurst site and Wodonga site. In the second task the capital structure of ARB ltd is to be analysed and also compared with a similar company belonging to same industry.

Part A

Capital Budgeting of Bathurst Site

                                                             

                                                                                                       Figure 1: (Capital Budgeting of Bathurst Site option)

                                                                                                                       Source: (Created by Author)

Capital Budgeting of Wodonga Site

                                                               

                                                                                                                 Figure 2: (Capital Budgeting of Wodonga Site option)

                                                                                                                                  Source: (Created by Author)

Capital Budgeting Analysis

As per the computation which are shown in the above figure for both the site which involves NPV analysis, analysis of profitability index and payback period (Sanchez et al., 2013). The results of the analysis quite clearly show that the clear option for the business is Wodonga site which has better NPV, profitability index and payback period as compared to Bathurst site. The NPV analysis for Wodonga site reveal that the NPV computed comes to $ 95,94,827 which is more than NPV of Bathurst site which is computed to be $ 58,44,567. The Profitability index shows that the Wodonga site has an index of 1.349 which is much more than Bathurst Profitability index which is shown to be 1.177 which signifies that Wodonga site is much more profitable than Bathurst site. The payback period analysis shows that the Wodonga site has the lower payback period which signifies that Saturn pet care will be able to recover the initial investment which the company spend on the production project. Thus, it is clear that Wodonga site is the clear option.

Product Cannibalization

This can be described as a technique which is used by businesses to promote or introduce new products in the market by reducing the sales volume of another product (Lin & Okudan, 2013). In the case of Saturn pet care, it is expected the management will be applying this technique in order to promote the new product of the business in the market.

Rectifying the Excessive Sales Recorded

The sales which is recorded and estimated by the marketing department of Saturn pet care as per one of the directors of the business has been incorrectly estimated and the accurate one might be a bit lower than what has been anticipated. Such an error in estimation can impact the decision-making process of the business and therefore needs to be rectified. The management can apply NPV method and increase the cost figures of the business so as to neutralize the erro in estimation.

Inclusion of Original Cost of Old Factory Shed

It is also the opinion of the director that the existing factory site which is vacant which is going to be used in the production process also must be included in the costs of initial investment made by the business. This is an incorrect estimation as NPV analysis only recognizes current investments which are undertaken for the project. Th initial investment must not include the such costs in the initial investment of the business.

Product Cannibalization

Part B

Introduction

This part will be analyzing the capital structure which is used by the business for the purpose of financing its operations. The later paragraph will also be containing an analysis which will compare the capital structure of ARB ltd and another company belonging to same industry. There will also be recommendations as to how the business can further develop.

Capital Structure and Cost of Capital

The capital structure of the company shows that it is made up of equity capital which shows the reliance of the company over the internal control of the business (Graham, Leary & Roberts, 2015). The company does not use any portion of debt capital in the capital structure of the company. The image which is related to the present capital structure is depicted below:

Weighted Average Cost of Capital below

The weighted average cost of capital which is shown in the table below shows that the cost of equity is 18.05%. As the company has no debt capital in the capital mix of the company therefore the cost of equity which is calculated becomes the weighted average cost of capital. The overall cost of capital has reduced from previous year and such a change is favorable from the point of view of the management.

Cost of Capital Under CAPM

As per CAPM method, the risks which is calculated following the value of by Beta (B), risk free rate of return and market rate of return for the purpose. This method is considered to be one of the most popular methods of analyzing a viability or the worth of a project (Baker & Wurgler, 2015). The cost of capital which is computed following CAPM approach comes to about 7.906% which is a favorable result as the market rate of return is 8.54% which means the needs of the shareholders are meet.

Comparison between ARB ltd and Modine ltd

For the purpose of conducting a comparative study, Modine ltd is selected which belongs to the same industry as ARB ltd. The first observation which is made judging by the capital structure of Modine ltd is that the company has a favorable capital structure and has employed both equity and debt capital which are $ 421.20 million and 519.90 million respectively. ARB ltd only has employed equity capital in the capital mix of the business.

Financial Ratios of ARB Ltd

The current ratio which is covered in the liquidity ratio of the business shows that the ratio has increased from previous year which suggest that the liquidity situations of the company has improved. The debt equity ratio shows a slight increase in the ratio from the previous year’s estimate (Fitó, Moya & Orgaz, 2013). The net profit margin of the company has reduced which may be due to some issues which the company might be facing with the operational activities of the business. The efficiency ratio of the business also shows favorable results especially inventory turnover ratio.

Changes in capital structure

The capital structure of the company has changed over the year as depicted in the image which is shown below after the explanation. In 2015 the company did use debt capital in the capital mix and since then the company has been following the equity capital only option.

Wealth Maximization

The company is committed toward the goal of the business which is to maximize the profits of the business. The NOPAT of the company has increased from the previous year however there has not been a significant growth in the NOPAT (Nakhaei, Nik Intan & Melati, 2013). This can be attributed to the various other factors which affects the NOPAT of the business.

Recommendations

The recommendations which can be provided are given below in detail:

1. The company must add debt capital in the capital mix so as to attain a favorable mix which can minimize the risks which are associated with the investment lines.
2. The company needs to formulate a strategy to improve the wealth maximization principle of the business (Jones & Felps, 2013)

Conclusion

The conclusion which can be drawn from the above analysis is that the business of ARB Ltd needs to add debt capital or borrowings in the capital mix of the business.  The company also needs to improve the wealth maximization principle of the business and also ensures that the risks are kept at minimum which can be done by getting a favorable capital mix.