Case Study: Looking Good Limited

A local company, Looking Good Limited, has been selling a rejuvenating face cream

for the last 12 months. Although the face cream performed well in the laboratory tests

conducted on rabbits, there has been an unfortunate side effect when the cream is

used on people over 40. The company has received a few positive comments from

satisfied male customers, but the number of complaints from women has been

increasing. The pharmacist responsible for developing the product conducted further

tests (this time on frogs) and found that the cream greatly increased facial hair.

Part One

The local law firm has always handled legal matters for

Looking Good. They have advised the company that a class action taken to court by

Looking Good's customers would be guaranteed to succeed. The lawyers estimate the court case would take one year to complete and that the judge would award $5000 per plaintiff. Louise Bloom, the managing director of Looking Good tells you that 10000 customers have been unhappy with the side effects produced by the cream. The management team at Looking Good has identified several ways of dealing with the situation:

1.

Purchase bonds that return 4% pa to create a 'damages reserve'. Louise Bloom wants you to tell her the dollar amount of a bond purchase made today that would provide sufficient funds to pay damages when the court case is settled. Coupons and face value would be used to settle the claims.

2.

Settle out of court. Louise Bloom wants you to tell her how much the company could offer the plaintiffs today and be indifferent to waiting for the court case to be settled.

3.

Get a big city lawyer. Louise Bloom has a cousin with a legal contact who estimates that the case could be delayed for a further year. This approach in unlikely to change the outcome, but will mean that Looking Good does not have to pay damages until 2 years from now.

Looking Good's cost of capital is 10%. Louise Bloom wants to know the maximum amount of money she would pay for the lawyer to use delaying tactics.

Required

a

Using TVM principles, determine which of the alternatives would you recommend if you were told the objective of the firm was to minimise the costs to shareholders?[5 marks]

b

Are there any ethical issues that might cause you to modify your conclusion? Why might ignoring such an issue have a negative effect on shareholder wealth? [6 marks]

[Total for Part One = 11 marks]

Part Two

Due to the amount of damages and legal expenses faced by the company, the management team has asked you as the company's finance manager, how they can manage their cash flows more efficiently. After discussing the matter with Louise Bloom, you think there could be significant savings if the raw materials inventory and accounts payable were better managed.

Raw materials

The main component of the raw materials inventory of Looking Good is lanolin. Being a natural product, lanolin has a shelf life of only 18 months before it has to be discarded. The company has made a large purchase of heavily discounted lanolin from a competitor's liquidation 2 years ago. About one third of this purchase was discarded in the last 6 months and the company has had trouble getting the inventory right ever since then. A new and regular source of lanolin has been found, but the supplier is located interstate so shipments take 2 weeks to arrive after an order has been placed. This has meant that Looking Good often runs out of lanolin, which is critical to almost

all their products. Management are reluctant to authorise large orders as they know that ordering too much will have an adverse financial consequence.

The line manager has estimated the usage of lanolin for the coming year as 1500 kilograms. The supplier will accept orders only in 50 kilogram lots at a price of $30/kg. The cost of placing the order is $75. Lanolin is quite bulky, so the carrying cost per kilogram is $2.50. To avoid running out of lanolin and holding up production, a safety stock of 100kg is to be maintained, even during the 2 week period it takes for a new order to be delivered.

Accounts payable

A second supplier of lanolin has been identified and has agreed to supply Looking Good for the same costs. The only difference between the two suppliers is the credit terms they offer. The first offers terms of 1/45 net 90, while the second gives 2/15 net 60.

Required

a Calculate the optimal order quantity of lanolin. [3 marks]

b Identify the number of orders that will be placed each year. [3 marks]

c Determine when new inventory should be ordered. [3 marks]

d Calculate the average inventory level under the new policy. [3 marks]

e Prepare a report that explains the methodology you have used and discuss your

results. [3 marks]

f Recommend which supplier should be used. [4 marks]

[Total for Part Two = 19 marks]

Part Three

Looking good is seeking to diversify and is evaluating several development projects for new cosmetics in light of recent legal matters. Although the cash flows are difficult to forecast, the company has come up with the following estimates of the initial capital requirements and NPVs for the projects. Given a wide variety of staffing needs, the company has also estimated the number of research scientists required for each development project. (All cost values are

given in millions of dollars.)

a. Suppose that Looking Good has a total budget of $60 million. How should it prioritise these projects? [5 marks]

b. Suppose that Looking Good currently has 12 research scientists and does not anticipate being able to hire any more in the near future. How should Looking Good prioritise these projects? [5 marks]

[Total for Part Three = 10 marks]