Case 2: Investing for Growth

One of Roberts plans was to invest $2.0 million in a new facility in order to increase production, satisfy future demand, and improve production efficiencies. For this particular project, he prepared the projected financial statements for the statements of income, the statements of changes in equity, and the statements of financial position for the first three years, 2016, 2017 and 2018 (see Appendix B). He presented these projections to Bill and Harry; both agreed with the planning assumptions used for the estimates.

As shown on the statements of income, the project is expected to generate $1.0, $1.3, and $1.5 million in revenue respectively for years 2016 to 2018. The projects profit for the year is estimated at $109,000, $240,000, and $300,000 for the same time period. The cost breakdown for the three-year period is also shown on the statements of income. Robert indicated that the project would last 10 years and that the numbers shown for the third year of operations would be extended (as is) from years 2019 to 2025. It was assumed that the inflation rate for revenues from years 2019 to 2025 would be partly offset by the inflation that will be incurred for cost of sales and distribution and administrative expenses. Robert was concerned about accurately predicting inflation rates for revenue and expenses beyond the third year.

The projected statements of financial position (also in Appendix B) show what the company will invest in each of the first three years of operations. The cost of purchasing the capital assets (property, plant and equipment) is estimated at $1.5 million, which would be invested in the latter part of year 2015. In 2016 (first year of operations), the company will also invest $200,000 in inventories and $100,000 in trade receivables. During the second year (2017), an extra $50,000 would be invested in inventories and $150,000 more in trade receivables.

The liability and equity accounts for the three-year period are also shown on the attached projected statements of financial position.

Some of the planning assumptions presented by Robert to Bill and Harry that were used to estimate the projects financial returns are as follows:

Cash outflow

2016 20172018

Investment in capital assets

Investment in land $100,000

Investment in buildings 800,000

Investment in machinery/equipment 600,000

Total investment in capital assets$1,500,000

Investment in working capital

Inventories$200$ 50

Trade receivables 100 150

Total investment in working capital$300$200

The capital cost allowance published by Revenue Canada for buildings is 5% and for machinery/equipment, 25%. The companys corporate income tax rate is 30%.

At the end of 10 years, Robert felt that they could sell the business for $2,950,000. For the purpose of this exercise, the existing companys financial statements are not considered part of this transaction.

Property, plant and equipment $ 700,000

Goodwill 2,000,000

Working capital 250,000

Total $2,950,000

The companys weighted average cost of capital is estimated at around 10% and Robert indicated that he was looking for a 20% internal rate of return (hurdle rate).

With regards to the cost structure used to calculate the break-even point, 50% of the cost of sales is considered variable and the rest, fixed while 20% of the distribution costs and administrative expenses are considered variable and the rest, fixed.

Case Assignments

1. Using the above planning assumptions, calculate the projects break-even points for years 1 to 3 by using Template 2 of the Part B - Decision-Making Tools spreadsheet templates.

2. Using the above planning assumptions, calculate the projects internal rate of return, the net present value (using a 20% discount rate), the profitability index, and the payback period by using Template 6 of the Part B - Decision-Making Toolsspreadsheet templates.

3. Using Templates 1, 2, and 3 of the Part A Financial Statements Analysis spreadsheet Templates, merge the companys financial statements with the projects financial statements for the years 2016, 2017 and 2018. For the purpose of this exercise, use Micro Tiles 2015 Statement of Income figures to also represent the companys figures for 2016, 2017, and 2018. For example, Micro Tiles 2015 figures should be added to the projects 2016 figures. Micro Tiles2015 figures should also be added to the projects 2017 and 2018 figures. You can also combine the project and the companys statements of financial position for the years 2016 to 2018 using the same columns. The merging of these financial statements will give some indication about the impact that the project will have on the companys overall financial performance.

(Note: The merging of these financial statements by adding the companys 2015 financial statements to the projects 2016, 2017 and 2018 financial statements is done because we do not have the companys projected financial statements for the years beyond 2015. In real life, the company would surely make a three-year forecast of its financial statements.)

4. Analyze the companys combined financial performance and compare it to the companys 2015 financial performance (without the project) done in Case 1 (Look Before you Leap).