Background information about Custom Snowboards Inc.
Banks are often interested in evaluating the ability of a company to repay a loan before lending money. In most cases, the ability to repay is measured by the profitability, solvency, and liquidity of a company. This section discusses the key points that a bank reviews before lending money to a company.
A banker will be interested in the movement of current assets, current liabilities, long-term liabilities, sales, net income, and total assets. The trend of these values gives information on profitability, solvency, and liquidity of a company. The current assets increased by 12.3% in year 13 and declined by 16.6% in year 14. The increase in year 13 was due to an increase in cash by 64.1% and a short-term investment by 20%. Further, the account receivable balance decreased by 6.4% in year 13. It increased later by 1.3% in year 14. The total assets declined by 0.5% in year 13. It declined further by 2.3% in year 14. The change in year 14 was caused by an increase in the value of furniture, fixtures, and equipment by 66.7%. Besides, there was a sale of the short-term investments amounting to $150,000. The proceeds were used to purchase assets. This indicates that the company does not invest back the profit earned. The current assets changed in the same proportion as sales.
The current liabilities decreased by 3.7% in year 13. It increased later by 0.7% in year 14. The accounts payable and notes payable declined by 6.4% in year 13. They increased later by 1.3% in year 14. The decline shows that the company does not make prompt loan repayments. The long-term liabilities decreased by 12.79% between year 12 and year 14. The current portion of long-term debt was $55,000 during the three years. It indicates that the company uses revenue to repay current loans. Mortgage payable and other liabilities decreased by 6.4% in year 13. It declined further by 6.8% in year 14. The total amount of liabilities decreased by 6% in year 13. It declined further by 5.8% in year 14. The trends show the company made consistent repayments of debts. It also shows that the management is efficient in repaying debt.
The ability of the company to repay the loan will be analyzed by evaluating the income statement. Sales declined by 6.44% in year 13. It increased by 1.28% in year 14. Gross profit and selling expenses changed in a similar percentage as sales. General and administrative expenses increased by 7.24% in year 13. It increased further by 6.5% in year 14. Even though sales increased in year 14, the net profit decreased by 67.66% in year 13 and further by 72.11% in year 14. The decline in net profit affects the ability of the company to repay the loan.
Historical analysis of past performance
This section provides an overview of the performance of the company between year 12 and year 14. Sales declined by 6.44% in year 13. It increased by 1.28% in year 14. Gross profit and selling expenses changed in a similar percentage as sales. General and administrative expenses increased by 7.24% in year 13. It increased further by 6.5% in year 14. The increase in the value of general and administrative expenses was caused by an increase in salaries, utilities, and other expenses. Further, interest income decreased by $2,200 while interest expense decreased by $5,000. These changes in the income statement caused a decline in the value of net income by a total of $146,025 between years 12 and 14.
The current assets increased by 12.3% in year 13 and declined by 16.6% in year 14. The increase in year 13 was due to an increase in cash by 64.1% and a short-term investment by 20%. Further, the account receivable balance decreased by 6.4% in year 13. It increased by 1.3% in year 14. Finally, the total assets declined by 0.5% in year 13 and declined further by 2.3% in year 14. The change in year 14 was caused by an increase in the value of furniture, fixtures, and equipment by 66.7%. Besides, there was a sale of the short-term investments amounting to $150,000. Account receivable decreased by 6.4% in year 13. The value increased by 1.3% in year 14. Inventory of raw materials changed at a similar rate as sales. Other current assets increased by 9.5% in year 13. The value increased further by 5.8% in year 14. Finally, the total assets declined by 0.5% in year 13. The value declined further by 2.3% in year 14.
The current liabilities decreased by 3.7% in year 13. It increased later by 0.7% in year 14. The accounts payable and notes payable declined by 6.4% in year 13. They increased later by 1.3% in year 14. The decline shows that company does not make prompt loan repayments. The long-term liabilities decreased by 12.79% between year 12 and year 14. The current portion of long-term debt was $55,000 during the three years. Mortgage payable and other liabilities decreased by 6.4% in year 13. The balance declined further by 6.8% in year 14. The total amount of liabilities decreased by 6% in year 13. It declined further by 5.8% in year 14.
The value of common stock and paid-in capital did not change over the period. Retained earnings increased by $66,375 over the three years. Finally, the value of total liabilities and shareholder’s equity changed by a total of 2.7% over the three years.
Analysis of what historical analysis indicates about future performance
An evaluation of past performance provides information that can be used to predict future performance. Analysis of the historical performance shows that sales increased between year 12 and year 13, and later decreased between year 13 and year 14. The past trend can be used to predict the future. Thus, in year 15, sales will increase by 3%. In year 16, sales will decline by 1% and later increase by 1.7% in year 17. Apart from sales, other items that depend on the level of sales will increase by the same proportion. Examples of these items are the cost of sales, current assets, and selling expenses.
Trend analysis
The net sales declined by 2.9% between year 12 and year 14. However, the forecasted trend analysis indicates that net sales will increase by 3.7% between year 14 and year 17.
Ratio analysis
The decline in the value of operating profit margin, net profit margin, return on assets and return on common equity between years 13 and 14 shows that the profitability of the company declined. The trend in the value of inventory turnover and average collection period between years 13 and 14 shows that there was no change inefficiency of the company. Further, the competitor performed better in terms of profitability and efficiency than the company. The current ratio and acid test ratio were high between years 13 and 14. This shows that the company is highly liquid. Further, the ratios were higher than those of the competitors. The leverage level of the company declined over the period because of the decline in the amount of debt. The solvency of the company declined over the period due to a decline in the amount of profit. The ratios indicate that the overall financial health of the company deteriorated over the period.
Cost control measures
The company uses the traditional method of costing to allocate production costs to the finished products. The method is easy to use though it does not provide an accurate cost of the units produced. Estimating the cost of the finished goods can be improved by using activity-based costing. When the traditional method is used, the regular snowboard costs $119 while the personalized snowboard costs $162. However, under activity-based costing the regular snowboard costs $105 while the personalized snowboard costs $218. Thus, the traditional costing exaggerates the cost of regular snowboards and understates the cost of personalized snowboards. Activity-based costing gives a fair amount of unit cost of the two products. The second cost control measure is the use of an efficient inventory management model. An example is the use of the just-in-time approach. In this approach, the management will purchase raw materials once it receives orders for production. This approach will reduce the current amount of inventory for raw materials. This in turn will release the resources tied to working capital.
Internal and external risks
A major internal risk that the company will face is the business risks that arise from expansion into a new region. The first business risk is the different accounting standards used in the United States and Europe. This difference may lead to inaccuracies in the financial statement. The company can mitigate this risk by recruiting accountants with knowledge of the accounting standards used by the two countries. The second business risk is the dissimilar pricing arrangement in the two countries. The price the company charges in the United States may not be similar to the price charged in Europe due to dissimilar pricing structures. The company can reduce this risk by carrying out extensive market research to enable it to come up with a suitable pricing structure for the European market. The research should entail economic analysis of Europe. Too high or too low price is not suitable for the company. The final internal risk is the lack of qualified personnel to manage the operation of the European market. The operations of the company in the European market may not be similar to the operations in the American market. Thus, the company may lack personnel for the new market. The company can reduce the risk by engaging the services of a consultant who is familiar with the operation in the European market. Besides, the company can train the employees before venturing into the new market.
On the other hand, the management may not be able to control the external risks because they arise from external sources. The first external risk that the company will face is the dissimilarity of in-laws and regulations in Europe and the United States. The company may face the risk of the increased cost of operation due to penalties that arise from non-compliance with the new laws and regulations. Training of the staff members on the new laws and regulations will mitigate this risk. The second external risk that the company may face is foreign currency fluctuations. This may arise from changes in economic conditions and the business environment in Europe. The risk can be mitigated through currency hedging and forward contracts. The final risk is the difference in culture and language of the two countries. This may create a barrier in carrying out operations in Europe. The risk can be mitigated by learning the new language and the European culture.
Potential returns of procuring a new plant
In this case, the analysis will emphasize the benefits of the construction of a new production plant in Europe. This method is known as direct expansion. In this approach, Custom Snowboards Inc. will enter the European market on its own. The capital budgeting techniques will be used to evaluate the viability of building a new plant in Europe. Specifically, the net present value and internal rate of return will be used.
“Net present value measures the difference between the present value of cash inflow and the present value of cash outflow” (Shapiro, 2005). It measures the present value of the net benefit from a project. The net present value criterion is a suitable measure of profitability because it looks at both the benefits and costs of a project. Also, it takes into account the time value of money. Incremental cash flows expected from a project need to be computed when using this approach. The total present value of the net incremental cash flow for the life of the project forms the basis for making decisions. A project is accepted if the present value of total incremental cash flow is positive.
However, if the total is negative, the project is rejected. A negative net present value implies that the present value of cash outflow is more than the present value of cash inflow (Shapiro, 2005). The calculation of the net present value of constructing a new plant in Europe is based on the forecasted cash flows for a period of five years that is, between year 15 and year 19. The net cash flows for year 15 amounts to $85,089, year 16 amounts to $121,294, year 17 amounts to $165,049, year 18 amounts to $205,328 and for year 19 amounts to $233,249. In addition, there will be a recovery of the salvage value of the machinery and working capital invested at the beginning of the project in year 19. The calculations yield a net present value of $83,373. The positive net present value implies that the project is viable.
On the other hand, the internal rate of return (IRR) is a unique discount rate which when applied to both cash inflows and cash outflows over the investment’s economic life provides a zero net present value (Powell and Baker, 2005). This implies that the net present value of a project calculated at IRR is zero. Most companies have a predetermined rate of return that is required by investors. Thus, the internal rate of return is often compared with the predetermined rate of return required by investors. A project is selected if the internal rate of return is higher than the rate of return required by investors. The internal rate of return that will be generated from the construction of the new project is 12.2%. The value is higher than the required rate of return of 10%. This implies that the project is profitable and worth pursuing. The two capital budgeting techniques indicate that building a new plant in Europe is viable.
Strategies for entering the new market
This section will analyze the total cost and returns for each of the options that the company can use to enter the European market.
Straight purchase over time
From the discussion in the previous section, the construction of a new production plant results in a positive net present value amounting to $83,373 and an internal rate of return of 12.2%. This shows that the project is viable. However, the present value of cash outflows when straight purchase over time is used amounts to $809,409 over the five-year period.
Sale-leaseback
The net present value criterion will be used to evaluate the approach. Under procuring a new building using the sale-leaseback approach the after-tax cash flows for each year will be $146, 250 between year 15 and year 19. In addition, the company will gain from a cash buyout amounting to $50,000 in year 19. Further, a 6% finance rate will be used as the discount rate in the calculation of the net present value. The present value of cash outflows when the sale-leaseback approach is used amounts to $653,355 over the five years. The method is suitable because it does not require an initial investment in working capital.
A comparison of the straight purchase over time and sale-leaseback option shows that the sale-leaseback will require less amount of the present value of cash outflows than the straight purchase over time. The result is based on the fact that the sale-leaseback will not require additional investment in working capital that will be required by the company to start operations. Thus, the sale-leaseback option yields savings in capital. Further, lease payments result in tax savings because it is an allowable deduction when computing taxable income. Besides, the company will not pay property tax that all property owners are required to pay. Therefore, the sale-leaseback option will be preferred to the straight purchase over time because it requires the least amount of the present value of cash outflows over the five years.
Merger
In this case, Custom Snowboards Inc. can merge with European SnowFun Inc. through a share exchange. The shareholders of SnowFun Inc. will receive one share of Custom Snowboards Inc. for three shares they own at SnowFun Inc. The earning per share for Custom Snowboards Inc. is $0.98 while for the European SnowFun Inc. is $0.27. A merger of the two companies will result in earnings per share of $0.92. Thus, it can be noted that shareholders of Custom Snowboards Inc. will not gain from the merger because the earnings per share will reduce from $0.98 (before the merger) to $0.92 (after the merger). On the other hand, the shareholders of European SnowFun Inc. will gain because their earnings per share will increase from $0.27 (before the merger) to $0.92 (after the merger). Further, it can be noted that the proportional interest of the shareholders of Custom Snowboards Inc. will reduce after the merger. On the other hand, Custom Snowboards Inc. will gain from established operations, employees and customers (DePamphilis, 2008). However, the company is likely to offer low-quality products that are produced by SnowFun Inc. This may lead to customer dissatisfaction. Further, the company may be forced to share vital confidential information with SnowFun Inc. This may reduce its competitive advantage in the region. Therefore, the approach is not recommended because it results in lower returns for the existing shareholders of Custom Snowboards Inc.
Acquisition
The final option entails buying SnowFun Inc. The European-based company will be acquired at $2.4 per share. The total purchase cost amounts to $720,000. The net cash flows of SnowFun Inc. amount to $1,007,605. The present value of the net cash flow amounts to $732,522. This yields a net present value of $12,522 ($732,522 – $720,000) over the five years. Thus, it can be pointed that the net present value that will arise from the acquisition is less than when the company builds a new plant. Thus, the method will generate a fewer amount returns to shareholders. Custom Snowboards Inc. will gain from established operations, employees and customers. On the other hand, the quality of the products may be compromised and this may lead to customer dissatisfaction.
From the discussion above, my recommendation would be to build a new plant in Europe with the sale-leaseback option. This strategy will result in a high amount of net present value and internal rate of return at a lower cost as compared to the other options. Besides, it results in lower tax expenses. The gains from this approach are greater than the gains from acquisition and merger.
Financing recommendation
The selection of the financing option which can be used by the company depends on the composition of the capital structure. The company can either use debt or equity financing or a combination of the two financing options. Analysis of the most suitable method of financing will be based on the impact of the financing option selected on the earnings before interest and tax of the company. A sensitivity analysis will be carried out at different proportions of debt and equity in the capital structure of the company. The recommendation will be based on the financing option that maximizes the shareholder returns. This will be measured using the earnings per common share stock. The table presented in appendix 1 shows a summary of the sensitivity analysis.
The use of 100% long-term debt results in the least amount of average net income totaling $71,008 and the highest average earnings per common share stock totaling $0.355 over the five-year period. Secondly, the use of 30% long-term debt and 70% common equity results in an average net income totaling $106,814 and the average earnings per common share stock amounting to $0.1942. Thirdly, the use of 80% long-term debt and 20% common equity results in an average net income totaling $81,502 and average earnings per common share stock amounting to $0.2722. Finally, the use of 100% common equity results in the highest average net income totaling $122,002 and the least amount of average earnings per common share stock totaling $0.1742 over the five-year period. Thus, based on the analysis, the use of 100% long-term debt will be selected because results in the highest value of average earnings per share stock and the least amount net income over the five-year period. Therefore, it will maximize shareholder returns.
Reference
DePamphilis, D. (2008). Mergers, acquisitions, and other restructuring activities. New York: Elsevier, Academic Press.
Powell, G. & Baker, H. (2005). Understanding financial management: A practical guide. Australia: Blackwell Publishing.
Shapiro, C. (2005). Capital budgeting and investment analysis. India: Pearson Education India.