Outcome of Capital Budgeting Technique Application
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.
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.
Product Cannibalization Strategy and its Impact
Nathan Quinlivan advises you that he is concerned about three issues:
That the possibility of product cannibalisation has not been considered;
Marketing estimates of year on year sales increases are high; and
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
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: http://library.csu.edu.au/services/find-books-and-other-resources/databases/subject/business)
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 (http://library.csu.edu.au/services/find-books-and-other-resources/databases).
Your report should include:
A brief executive summary.
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 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.
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.
Marking criteria
Where necessary, state any assumptions you have made. Assignments should show all workings and students will be penalized for failing to do this.
Outcome of Capital Budgeting Technique Application
The above figure shows that capital budgeting technique application shows the best option available to Saturn pet care for starting the production process is Wodonga site which is clearly shown following all the methods of capital budgeting such as NPV analysis profitability index and payback period analysis (Fauzi, Basyith & Idris, 2013). The NPV method shows that the future cash flow which the business can expect from the production site of Wodonga Site is more than the Bathurst site. The NPV of the Bathurst site is shown in the above figure as $ 58,44,567 which is less than the NPV which is calculated for Wodonga site which is $ 95,94,827. The profitability index shows that for Bathurst site the index is 1.117 which is less than profitability index of Wodonga site which is 1.349. The payback period analysis also shows that Wodonga site is much better option than Bathurst site it allows the business to recover the initial investment amount for the production in less time period. Thus, from above analysis it is clear that the most profitable site for production is Wodonga site.
The term product cannibalization refers to a strategy which is often followed in business where in order to introduce and promote a new product in market, the business reduces the sales of another product (Lin & Kremer, 2014). In the case of Saturn Pet care, it may be very well be possible that the business is using such a technique in order to promote the new product which the management plans to introduce.
As per the question, Nathan who is one of the director of the business is of the view that the marketing department has estimated the sales in excess and therefore the same needs to be rectified so that it does not impact the panning process of the management. The estimation error can be rectified by following NPV method in which the cash outflow estimates can be increased slightly so as to neutralize the estimation error caused previously (Kumar, Sharma & Tewari, 2015).
Nathan also is of the opinion that the original cost of the factory site should be included in initial investment so as to bring about a correct estimate. The judgement of Nathan is incorrect as NPV analysis only takes into consideration the newly developed factory site which has been developed for the production site option.
This part will be dealing with the analysis of the capital structure of ARB Ltd which is engaged in manufacturing business and the effectiveness or weaknesses of the capital structure is to be identified. In coming paragraphs, detailed analysis of capital structure and it changes over the years have been conducted.
The capital structure of ARB Ltd shows that the company only employs equity share capital in the capital mix which is used by the company (Barth, Konchitchki & Landsman, 2013). The company does not employ any debt capital in the capital mix and the capital structure of the business is solely comprised of equity capital. The present capital structure of the company is shown ion the table below:
Product Cannibalization Strategy and its Impact
The weighted average cost of capital for the company as revealed by the computation reveals that the WACC of the company comes to 18.05%. WACC is the average of all cost of capital from different sources of finances which are employed by the business. The overall cost of capital has reduced from previous year’s estimates which shows that the cost of financing has somewhat reduced which is a positive sign (Frank & Shen, 2016). The WACC for 2016 was 19.01% which has reduced to 18.05% in 2017.
The cost capital when computed under CAPM approach considers a number of variable such as risk-free rate of return, market rate of return and Beta which is the risk factor (Johnstone, 2016). The cost of equity as per CAPM approach is computed to be 7,906% which is favorable considering the market rate of return which is 8.54%. This signifies that the expectations of the shareholders are meet.
For the purpose of Comparison, Modine ltd which is engaged in same industry and has similar operation as ARB ltd is selected. The capital structure of Modine ltd is made up of both equity and debt capital. This shows that the business is trying to achieve a favorable capital mix which can reduce the overall risks of the business. In case of ARB Ltd, the capital structure is only made up of equity share capital. The equity and debt capital which is used by Modine ltd is shown at $ 421.20 million and 519.90 million respectively. This shows that Modine Ltd has a better capital structure as compared to ARB ltd.
The financial ratio of the company depicts profitability, solvency and efficiency ratio as shown in the figure shown below (Pervan & Kuvek, 2013). The current ratio of the company as shown in the table below has increased from previous year estimate which shows that the liquidity position of the company has improved (Kohansal et al., 2013). Another significant ratio which is needed to be considered is debt equity ratio which has increased from previous year suggesting rise in debts. Another positive is inventory turnover ratio which has increased from previous year as well which is a positive sign.
The capital structure has changes over the years which is evident from the table which is shown below. In current scenario the business only uses equity capital mix in the capital structure of the business.
The company has not been able to achieve the growth which the company has expected to achieve. Even though the NOPAT of the business has increased slightly, the company needs to put more focus on wealth maximization principle (Fernandez, 2015).
Conclusion
The recommendation which can be suggested to ARB Ltd are given below in points:
- The company needs to formulate a strategy to improve the wealth maximization principle of the business(Jones & Felps, 2013).
- The company needs to incorporate debt capital in the capital structure of the company so as to attain a balanced and favorable capital structure mix.
Thus, it is clear that ARB Ltd needs to improve the capital structure of the company by adding debt capital and attaining a balance which in turn can reduce the risk associated with capitals efficiently. The company also needs to maximize the wealth of the shareholders of the business.
Reference
Barth, M. E., Konchitchki, Y., & Landsman, W. R. (2013). Cost of capital and earnings transparency. Journal of Accounting and Economics, 55(2-3), 206-224.
Fauzi, F., Basyith, A., & Idris, M. (2013). The determinants of capital structure: an empirical study of New Zealand-listed firms. Asian Journal of Finance & Accounting, 5(2), 1.
Fernandez, P. (2015). EVA and cash value added do not measure shareholder value creation.
Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of Financial Economics, 119(2), 300-315.
Johnstone, D. (2016). The effect of information on uncertainty and the cost of capital. Contemporary Accounting Research, 33(2), 752-774.
Jones, T. M., & Felps, W. (2013). Shareholder wealth maximization and social welfare: A utilitarian critique. Business Ethics Quarterly, 23(2), 207-238.
Kohansal, M. R., Dadrasmoghadam, A., Mahjori Karmozdi, K., & Mohseni, A. (2013). Relationship between financial ratios and stock prices for the food industry firms in stock exchange of Iran. World Applied Programming, 3.
Kumar, R., Sharma, A. K., & Tewari, P. C. (2015). Cost analysis of a coal-fired power plant using the NPV method. Journal of Industrial Engineering International, 11(4), 495-504.
Lin, C. Y., & Kremer, G. E. O. (2014). Strategic decision making for multiple-generation product lines using dynamic state variable models: The cannibalization case. Computers in Industry, 65(1), 79-90.
Pervan, I., & Kuvek, T. (2013). The relative importance of financial ratios and nonfinancial variables in predicting of insolvency. Croatian Operational research review, 4(1), 187-197.
