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Office Equipment Limited - Business Operation and Finances Options

Background

Case 1

Office Equipment Limited 

Background

Student Office Limited is a newly formed company in Nicosia producing complete office equipment for students. The company will produce a standard size office equipment satisfying the basic office needs for a student. It is estimated that the product will attract the new students of Nicosia’s four Universities who rent apartments in and around the city of Nicosia. The idea came from three new business graduates of the University of Nicosia, who are the directors of the newly established company. The product will be delivered at the student’s apartment upon order. It will be displayed in a small show room created for the purpose, at the premises of the company in Strovolos, south of Nicosia. The premises include the production area, the stores, the offices of the company and the small show room. It estimated that production will be carried out uniformly during the year accumulating the stocks required to meet the expected demand at the peak season period of August-September each year.

The Business Operation and Finances

It is estimated that the annual demand will be approximately 700 units.  The product will be promoted through a promotion campaign in the period 15 July to 15 September each year. The project will last for four  years at the end of which the directors of the company plan to expand their business on the basis of the acquired experience by then, to produce other standard products such as living rooms, kitchens etc. The company has two options: 

Option 1: To rent the premises for an annual cost of €48,000 (a monthly rent of €4,000). Running and other fixed expenses under this option will be €11,000 per year and the variable cost per unit €250. 

Option 2: Involves the lease of other premises for a period of four years for a total of €200,000 to be written off (amortized) on a straight line method over the entire period of the lease. Running and other fixed expenses under this option will be €25,000 per year and the variable cost per unit €200.   

Both options will be supported by a promotion campaign with an annual fixed cost of €25,000. It is estimated that the annual demand for the product will be 700 units and that the selling price will be €400. This is irrespective of the option of production that it will be chosen by the company. 

The Business Operation and Finances

Under both options the performance and the further development of the company will be evaluated by the end of the four year period which is considered to be the “trial period” for such a business type in the small market of Cyprus. 

The table below summarizes the proposed options with costs and revenues analysis. 

 

Option 1

Option 2

Selling Price (€)

400

400

Lease Annual Amortization (€)

 

50,000

Annual Rent (€)

48,000

 

Annual Campaign Cost (€)

25,000

25,000

General Fixed Costs (€)

11,000

25,000

Unit Variable Cost (€)

250

200

Expected Annual demand (Units)

700

700


It is understood that the rental contract as well as the lease contract cannot be changed during the four year period. 

End of Case 1

Prepared by Marios Christou, University of Nicosia, December 2018

Question  for Case 1 

Prepare an analysis for the directors of Student Furniture Limited, as far as the information provided permits, to suggest which method/option to choose.

Case 2 

Wholesale Trading Limited

Background

Wholesale Trading Limited is a wholesale private company that operates as an importer and distributor based in Nicosia, Cyprus.  The company imports mainly children toys and souvenirs. The Company’s turnover for the year just ended (2018) was €4.8m down by €1.2m compared with its 2017 turnover of €6m. The drop in the company’s turnover was discussed at the Board’s special meeting last week. The main conclusion was that the 20% drop in the company’s turnover between 2017 and 2018 was due to the poor response of the market. However it is estimated that the €4.8m turnover of 2018 will remain unchanged for 2019, thus the annual sales level is expected to stabilize.  

The board has examined the preliminary results of 2018 in comparison to those of 2017 which clearly show substantial drop in the Earnings Per Share (EPS) of the Company.  The EPS in 2018 have been half of those achieved in 2017 and of course the main shareholder, the Michael’s family, which controls 80% of the share capital does not feel happy. It has always seen Wholesale Trading Limited as a milk cow for its other business activities drawing the full amount of EPS achieved every year as dividend (the company has in issue 1m ordinary shares of €1.00 each).  

Finances

The audited Income Statements for Wholesale Trading Limited for 2017 and the un-audited of the last year (2018) show the following:

Turnover

4.80

6.00

Cost of Sales

3.60

4.50

Gross Profit

1.20

1.50

Selling and Distribution Expenses

0.15

0.15

Administration Expenses

0.40

0.40

Finance Expenses

0.25

0.15

Total Operating Costs

0.80

0.70

Net Operating Profit (profit before tax)

0.40

0.80

EPS (see note at the end of the case)

36c

72c


Wholesale Trading Limited

Income statement

Based on the results of 2018, the directors have discussed the possibility of increasing the profitability of the business by looking at its operating cycle, its administrations expenses and its selling and distribution expenses. A close examination on the efficiency of operating the Company’s working capital has revealed that its stock turnover period was 3 months, its debt collection period was 2 months and its credit period taken 1 month. 

Option 1: Rent the Premises

The New Working Capital Operation and Costs Reduction Proposal  

The new working capital operation proposal involves a change in the operating policy of the Company’s working capital such that,  the Stock turnover period to be reduced from 3 to 2 months, the debt collection period from 2 to 1 months and an extension of the credit period taken from 1 to 2 months. Since the company has an available working capital to finance its operations of €100,000, and the rest of its cash requirement is financed by an overdraft facility at an annual cost (interest on overdraft) of 15%, it is estimated that on the basis of the 2018 turnover, the 2019 EPS will be restored to its 2017 level. This will be achieved by assuming that the terms of trade will remain unchanged (ie the gross margin will not change) and that there will be a reduction in the administration expenses of €0.175m and in the selling and distribution expenses of €0.075m. The drastic expenditure cuts will be achieved by making redundant a number of employees, by applying a 20% salary reduction to the remaining staff and by applying tide measures on the general expenses and the selling and distribution expenses of the Company. 

Note: Corporation tax is 10%. This is applied to the net operating profit since all company expenses (including finance expenses) are considered for the calculation of the net operating profit. Thus EPS are calculated on Net Operating Profit after the deduction of 10% corporation tax.

End of Case 2

Prepared by Marios Christou, University of Nicosia, December 2018 ©

Question  (for Case 2) 

You have been asked by the board of directors of Wholesale Trading Limited to independently advise them on the viability of the proposal, clearly showing how the working capital structure of the company will change, to reflect the proposed reduction on the cost of the overdraft borrowing, which is used to finance the existing working capital requirement of the business.  

In your answer, given the proposed Working Capital and Cost Reduction Model, you should include the projected Income Statement of Wholesale Trading Limited for 2019.  

On the basis of the proposed plan, show how the EPS of Michal’s family will return back to the 2017 levels at the end of 2019, indicating that if the EPS are issued as dividend in full the dividend income of Michael’s family for 2019 is expected to be €576,000.  

Option 2: Lease Other Premises

Case 3 

Investments Limited 

Background

Investments Limited is an investment company, specializing in investing in small private equity companies. The objective of the firm is to maximize the return to its investments (ie to its shareholding in shares of companies into which it invests creating its investment portfolio in an attempt to maximizing its Earnings Per Share - EPS). 

Investments Limited usually undertakes to invest in companies facing financial and liquidity problems. Its strategy is to take over such companies (ie to buy their share capital or the majority stake in it), to restructure the capital and by “injecting” the required long term capital to turn them into profitable entities. What it tries to do is to maintain a “profitable” leverage (gearing) in the long term capital of these companies. Thus the ultimate objective is to invest in the share capital of such companies in a balanced way, so that by obtaining a suitable long term loan (usually in the form of fixed interest long term debt) to create a long term capital structure to allow for maximizing earnings per share.

An Investment Opportunity

Currently Investments Limited is examining an investment opportunity. A sea-side restaurant in Limassol, the second largest coastal city of Cyprus is running into difficulties. The restaurant is owned by LSS Restaurants Limited. The only activity of LSS Restaurants Limited is to own and run this restaurant, which Investments Limited is considering to take over.  It is estimated that with a €300,000 investment in the long term capital of the company (LSS Restaurants Limited) Investments Limited will take over the operation and will turn it into a profitable business by introducing major changes which are expected to change the restaurant’s character and its management structure.      

Proposed Financial Plan

The proposed financial plan has two options on which the directors of Investments Limited are expected to decide on the basis of their strategy objective which is to maximize the company’s return on its investments, measured on the basis of the EPS it can achieve. The two options discussed are the following:

Option 1:

To invest €300,000 into the share capital of Restaurants Limited, which represent the entire total long term capital of the company. This will involve the issue of 300,000 ordinary shares of €1.00 each of Restaurants Limited to Investments Limited.

Option 2:

To invest €200,000 into the share capital of Restaurants Limited, which represent 2/3 of the entire long term capital of the company. This will involve the issue of 200,000 ordinary shares of €1.00 each of LSS Restaurants Limited to Investments Limited. The rest of the long term capital requirement of €100,000 will be financed through the issue of a 5% 15 year corporate bond. 

Thus the proposed long term capital structures of the two options proposed for LSS Restaurants Limited is summarized as follows:

 

Option 1

Option 2

Ordinary Shares of €1.00 each

300,000

200,000

5% 15 year Corporate Bond1

 

100,000

Total Long Term Capital

300,000

300,000


Profitability

The directors of Investments Limited have looked at the operational plan of LSS Restaurants Limited and they anticipate that the company’s (LSS Restaurants Limited) expected annual profitability will be at least €15,000 (pessimistic scenario) before interest and tax (currently corporation tax rate in Cyprus is 10%). The expected annual profitability level (most likely scenario) is €25,000 before interest and tax while an optimistic scenario suggests that the annual profitability can reach the level of €35,000.    

1 The 5% 15 year Corporate Bond is expected to be an unsecured Corporate Bond issued directly by LSS Restaurants limited. It has already been agreed with an investment bank that Investments Limited co-operates that, should it finally decides to invest €200,000 in the share capital of LSS Restaurants Limited the bank will be willing to invest in the Corporate Bond without asking for the provision of any further securities.             

End of Case 3

Prepared by Marios Christou, University of Nicosia, December 2018©

Question  for Case 3

Analyze the expected earnings per share of LSS Restaurants Limited for each of the two proposed options on the basis of the three profitability scenarios.   

In your answer discuss the advantages and disadvantages of the two options for MCC Investments Limited and suggest to its directors which option they should adopt. 

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