Financial Management
Case Study Spring 2016
Rich Confectionaries Company
John Rich the co-owner of Rich Confectionaries and plant manager picked up the telephone to call the firm’s Sales Manager. The Sales Manager had sent him an email suggesting that Rich Confectionaries might be able to increase its profits substantially if he were allowed to increase the production capacity for a new home brand chocolate that he planed to introduce for sale in convenience stores. The plan was to provide convenience stores, like “7 eleven” with their own brand of chocolate for sale at the counter. It would be a high-margin product that was currently being sold in bulk to large department stores for their own use in house branding sales. If they went ahead with this new product the company would be able to sell the new product at a higher price than the current price to department stores. The Sales Manager was really pushing this point to John, however his real motivation was that he was banking on getting a big increase in his bonus payment.
“Your suggestion interests me,” said John Rich, “but I can’t give you an answer until the financials have been worked up to show that profits from the increased sales you expect to get will give us a big enough return on our capital investment”. As soon as you have firm estimates for sales and how much you will need for advertising and promotion, give them to Stephanie Rich (the company’s controller and another major owner). She can get the other data she needs to make the calculations from purchasing and production, and I will ask her to send me her recommendation by early next week. If it is as profitable as you think it will be, we will move on it immediately.”
Rich Confectionaries has been in business at the same location for over 80 years. It was the first chocolate company to locate in the Blue Mountains for the cooler temperatures for storing chocolate, and it remains by far the largest family producer of confectionaries in the country. Although the company has entered into a number of licensing agreements with overseas producers it continues to operate as a family run business. In addition to the title of plant manager, John Rich also serves as a member of the board with his sister and other family members. The Rich Confectionaries factory produces a large range of products, from standard family block chocolate, to elaborate commemorative chocolate pieces. Approximately 40 percent of the plant’s current output is sold under the Rich Confectionaries label, with the remaining production sold in bulk to department stores. The product line in which the Sales Manager wants to expand production was first introduced in 1989 under the Rich Confectionaries brand name, but its real sales growth came in the late 1990s. At that time, contracts were signed that provided for bulk delivery to several large department stores for branding and sale under their own labels. In the past few years the Sales Manager has had inquiries from several other companies about similar arrangements, but the present production facility is already producing at its full designed capacity.
Before writing the email to Rich, the Sales Manager had discussed the expansion idea with another family member who is on the board who is also head of the production department. According to Production Manger there is no room to expand production capacity in the present factory. The factory is located in a small industrial zone at Springwood several kilometres from the main plant at Katoomba. Other tenants presently occupy all of the available land and buildings adjacent to the Springwood operations. However, the production manager has heard of a company that is going into receivership, whose manufacturing plant is very near the main factory and this factory space should become available for lease very soon. This factory space has the required floor space, power, water and gas supplies already in place that Rich Confectionaries needs, and it can be leased for 10 years at a rental of $325,000 per year. “I have wanted to get rid of that stupid small factory for years it costs me a fortune in sending maintenance staff over there” said the production manager. “It is a real inconvenience for me to have to go all the way over there whenever they have a problem and they have quite a few since they have to operate at full capacity all the time. Moving to a location practically across the street from the main plant and expanding capacity would really make things easier for me. You can count on my help in convincing the board to make the move.”
Working with Production Manager, the Sales Manager prepared some preliminary estimates on the back of a scrap piece of paper, which showed a payback in less than one year. This was based on sales of 100,000 units at $100 per presentation box giving $10 million of income less expenses of around $6.6million, thus the net profit would be $3.3 million with an initially outlay of only $2.7 million. As he gave this quick calculation along with more detailed supporting documentation to Stephanie Rich, the Sales Manager remarked that a one year payback was hard to beat. He also noted that the production manager wanted to move on the project quickly, so he hoped that Stephanie would not delay in passing the proposal on to John with her full support “it was in the family’s best interests”.
After glancing at the detailed figures in appendix 1, Stephanie noticed several problems. First, the sales and expense numbers discussed are not expected to be achieved until Year 5. Hence, the apparent profitability is probably overstated. Second, they represent total sales and expenses. Rich Confectionaries is already producing 50,000 units per year in its existing location, and Stephanie believes that it would be improper to use profits on existing sales to justify the expansion. In other words, what she needs is an incremental analysis of the costs and benefits that are associated with making the move and that would not occur if the proposal is rejected. Third the estimates did not include the $500,000 in market research the Sales Manager had spent over the past two years researching this idea which had culminated in his proposal.
The figures for the first few years shown in appendix 1 represent an introduction period in which marketing efforts are to be directed at several potential key customers. Stephanie knew that sales increases of this order of magnitude would require substantial amounts of new working capital. From other expansion decisions that had been undertaken in the past, Stephanie estimated that the current level of $450,000 would be sufficient if the move is not made to the new location. However if the move is made, a total of $540,000 will be needed at the beginning of the first year. As sales will increase in year three, this figure will increase to a total of $720,000 at the start of Year 3, and a further increase to a total of $900,000 at the start of Year 5.
Stephanie also questioned the Production and Sales Manager about the old plant and equipment, some of which is to be moved from the old to the new facility. They advised the old plant would have to be scrapped, as it will not meet the new production figures. “It is fully deprecated on the books and also for taxation purposes but could be sold for $175,000 today. The new plant would cost $2.5 million. However the chocolate moulds, cooking pans and wrapping equipment will be moved to the new facility. It is still on the books at a value of $150,000, which is also its tax book value. The depreciation for management purposes and tax is $50,000 per year for the next three years. It will cost us $50,000 to move them to the new building, and reinstall. If we wanted to get rid of it and buy all new equipment, I could probably sell it for its book value, but the new equipment we would have to buy costs over $500,000. I see no reason to replace the moulds, pans or wrapping equipment since it is all in good shape and will last the ten years.” All agreed it would be silly to sell the old chocolate moulds, cooking pans and wrapping equipment and then replace them with new that was just wasting $350,000 for no extra benefit.
Both Stephanie and Sales Manager agree that the new facility should be able to operate profitably for many years. The Rich board had decided that a study life of ten years, the standard used by the company, would be employed in the analysis. At the end of ten years, the market value of the plant is estimated to be $500,000 but the equipment (chocolate moulds, cooking pans and wrapping equipment) will be worth nothing. It is assumed that the full value of the working capital can be recovered.
When evaluating capital projects Stephanie uses a real cost-of-capital of 15 percent and a tax rate of 30 percent. Rich Confectionaries also has a company policy of using straight-line depreciation for management reporting purposes over the life cycle of the product. Under the tax guidelines, the new equipment is classified as a five-year asset and is eligible for a 20% straight-line depreciation rate.
Additional Information
. All costs and income figures are in constant dollars at 2016 levels.
. Company tax rates are 30% and paid at the end of year. Rich Confectionaries expects to be paying tax at the company tax rate of 30% indefinitely.
. The expected inflation rate for the next ten years is expected to be 3% pa.
. Removal and relocation costs are an allowable expense for tax purposes when paid.
. Debt finance costs 10.5% pa for companies like Rich and the loan repayments if Rich borrowed the funds would be $449,000 per year for ten years
Exhibit 1
All Figures Constant Dollars
Estimated Sales, Production Costs, Marketing Expenses and Other Expenses
Sales Estimates
Boxes
Revenues Marketing Expenses
Status quo Sales at $80 per box
New Facility
Years 1–2 50,000 @ $80
10,000 @ $110
Years 3–4 50,000 @ $80
25,000 @ $110
Years 5 -10 50,000 @ $80
50,000 @ $110
Cost Estimates
50,000
60,000
75,000
100,000
$4,000,000
$5,100,000
6,750,000
9,500,000
$87,500
$487,500
$387,000
$153,000
Variable Costs Annual Fixed Costs
per Box
Lease
Deprtn.*
Other#
Status quo
New Facility
Years 1-2
Year 3
Year 4
Years 5-10
$60.00
$59.00
$56.00
$56.00
$50.00
$100,000
$325,000
$325,000
$325,000
$325,000
$50,000
$320,000
$320,000
$270,000
$270,000
$125,000
$300,000
$300,000
$300,000
$300,000
*These amounts are for reporting purposes and are based on a 10-year life, straight-line rates, and zero salvage values.
# The amounts include in status quo an amount of $50,000 per year representing actual cash cost for inter-factory transfers/transport which includes maintenance staff, transfer of parts and raw materials.
Also included under New Facility “Other”, there is an amount of $5,000 per year representing the amortisation of the removal and relocation expense for the moulds, pans and wrapping equipment.
The Sales Manger’s scrap paper workings
QUESTIONS
• Identify the incremental cash flows for this project (ie produce a table of the incremental cashflows for capital budgeting analysis).
Please use the excel you marks (13 marks)
• Write a brief executive summary to John Rich giving your recommendation? Include a summary of your workings supporting your recommendation.
Make sure you look at the guide to writing assignments on how to do an executive summary which must not be more than one page in length (3 marks)
• Sales Manager used the payback period as an indicator of the merit of the move to the new facility. Is this decision criterion the one that should be used? Give reasons why you would use this criterion and one why you would not. (2 mark)
• What others factors should Rich Confectionaries consider? (2 marks)
