Memorandum
To: Chief Financial Officer, Superior Living Incorporation.
From: Vice President Finance, Superior Living Incorporation.
Date:
Subject: Evaluation of New Production Plan and Initial Public Offering for Superior Living Incorporation.
This report includes the merits and demerits for Superior Living Incorporation about IPO and the development of a new product line. Moreover, the report also presents a discussion related to the hurdle rates which are expected not to be overcome by the new product line and key financial indicators useful in reaching an appropriate decision in the scenario under consideration, which include payback period, net present value, internal rate of return, modified internal rate of return.
For analysis and discussion presented in this report, the income statement and balance sheet of the company have been used. Also, the information presented in the income statement and balance sheet of the company has been used to determine the metrics considered pertinent for decision making and evaluating the viability of new product lines and other options.
Pros and Cons for Superior Living Incorporation of Going Public
Following are the potential benefits of going public for Superior Living Incorporation:
- Keeping in view the fact that the company needs to raise finance for its new product line, opting for Initial Public Offering would help the company to have access to finance (Lipman, 2009).
- Another benefit of going public is that the company would be able to make use of its stocks in acquiring other businesses. For instance, by making acquisitions through issuing new stocks (Gregoriou, 2011).
- If Initial Public Offering (IPO) is successful then there is a strong chance that the shareholders of the company will get rewarded financially (Lipman, 2009).
On the other hand, the following are the potential drawbacks or disadvantages of going public for Superior Living Incorporation:
- Being a newly established public company, if the decision to go public is taken, there will be significant pressure on the management and board of directors of the company to come up to the expectations of shareholders (Moyer, McGuigan, & Kretlow, 2001).
- Keeping in view the fact that the current market situation in the United State is still volatile, credit rating agencies are still careful in giving full clearance to new investors in the US market (Mullaney, 2013). Based on this existing volatility in the market, it may be a matter of concern for Superior Living Incorporation as to when shall it go for public offering.
- One other disadvantage of going for a public offering would be that the market price of the company’s newly issued stocks would be dependent on the market dynamics. Since the product to be launched by Superior Living Incorporation is already manufactured by its competitors, therefore there will be nothing new and attractive for the investors to invest in the company’s stocks, which could result in a significant decline of company’s stocks value (Gregoriou, 2011; Lipman, 2009).
Hurdle Rate
If the hurdle rate for the new product line is set to be 18 percent or below, it is projected that this rate will be surpassed by the launch of the new product line. However, any hurdle rates more than this rate will result in the non-acceptance of the project (Lasher, 2010).
Debt vs. No Debt Option
As noted in the previous section, a rate of 18 percent, as a hurdle rate, is acceptable for the launch of a new product line; however, a careful analysis of sources of finance for the project is required. The only major issue which the company may face upon accepting this new product line would be cash flows. If debt financing is preferred by the company to ensure liquidity and availability of cash, the cost of capital would increase significantly, therefore, reducing the overall profitability of the company in long run. On the other hand, internal financing will although reducing cash flows and current assets of the company but would improve once inflows from the new product will begin (Madura, 2009; Arnold & Kumar, 2008).
Key Financial Metrics and Evaluation of New Product Line
Upon determining the payback period for the investment in the new product line, which has come out to be less than 2 years and 9 months, it can be stated that the return on investment will be favorable for Superior Living Incorporation. Considering the financial information presented in the income statement and balance sheet of the company, the modified internal rate of return, internal rate of return and the net present value of investment have been determined as follows:
Keeping these financial metrics in view, it appears that the new product line is feasible for the company to begin. However, while reviewing the information presented in the financial statements of the company, some issues may be considered as an increased risk. The foremost issue in this regard is the liquidity position of the company. Upon reviewing the balance sheet of the company for the years 2001, 2002, and 2003, it is observed that there is a significant portion of inventories in the current assets of the company, which significantly lowers the current assets (fewer inventories) as compared to current liabilities of the company. The details of current assets, inventories, and current liabilities are presented in the table as follows:
Taking into account the above-presented information, it can be stated that the company’s liquidity position is not favorable. Moreover, the fact that there is a large proportion of inventories in the current assets could influence the liquidity position of the company in the future if the company is not able to sell its inventories, there may be a severe decline in the available liquid assets for the company. Apart from the fact that this situation may result in an unfavorable situation for the company, however, given the scenario that the company decides to adopt the new product line, this risk may be mitigated as returns expected would cater to the liquidity risk.
Recommendations
The analysis and accompanying discussion presented in this report conclude that it is not favorable for Superior Living Incorporation to go for public offerings and raise finance for the new project through issuing its stocks. However, the project appears to be favorable for the company as a whole because the modified internal rate of return and net present value are all in favor of the project. Considering this situation, it is recommended that the launch of a new product line shall be accepted, but the financing of this new product line shall be done through internal financial sources of the company rather than relying on external sources of finance such as debt financing or equity financing (Arnold & Kumar, 2008; Moyer, McGuigan, & Kretlow, 2001).
References
Arnold, G., & Kumar, M. (2008). Corporate Financial Management. New Delhi: Pearson Education India.
Gregoriou, G. N. (2011). Initial Public Offerings (IPO): An International Perspective of IPOs. London: Elsevier Finance.
Lasher, W. (2010). Practical Financial Management. Mason: CENGAGE Learning.
Lipman, F. D. (2009). International and US IPO Planning: A Business Strategy Guide. John Wiley & Sons: New Jersey.
Madura, J. (2009). International Financial Management (10th ed.). Mason: Cengage Learning.
Moyer, R. C., McGuigan, J. R., & Kretlow, W. J. (2001). Contemporary Financial Management. Cincinnati: South-Western College Publishing.
Mullaney, T. (2013). Fitch warns the U.S. risks losing AAA debt rating. Web.