Heavy Keele Ltd. (HK) has a long-standing reputation as a manufacturer of quality sailboats. HK currently produces two different models of sailboat from a single production facility the HK41 and the HK49. The past several years have seen a 25% decline in demand for HKs sailboats and a significant increase in interest within the boating community for motor vessels. Given this shift in attitudes, HK is now considering a proposal to introduce a motor vessel into its product line the HKMV55.

If the proposal is accepted, senior management has decided to restructure the firm into two separate divisions for operational purposes the Sailboat division and the Motor Vessel division. Under the proposal, all current personnel will remain with the Sailboat division and the senior management team will remain unchanged. For accounting purposes, however, the $2 million annual cost of the senior management team will be allocated equally between the two divisions. HK will then seek an entire new management team to oversee the Motor Vessel division. Management has also decided that the new division should operate out of its own production facility. It can be built on the block of land adjacent to the current facility that HK already owns.

Senior management has decided that the appropriate planning horizon for the proposed new Motor Vessel division is 10 years. You work in the controllers office of HK and have been asked to perform a series of analyses on this proposal. To facilitate your analysis, you have been provided with the Motor Vessel divisions projected income statements over the next 10 years, as well as the following information.

The new Motor Vessel division requires an initial investment in net working capital of $750,000.

Operating revenues and expenses, and working capital accounts

Data from the divisional pro forma operating income statements (see Appendix): o Gross revenues are projected to be $12.5 million in the first three years of

operation and $18 million from Year 4 onward.

o Cost of goods sold (COGS) is expected to be 56% of sales in the first three years and then decline to 50% of sales from Year 4 onward.

o The general and administrative costs are expected to be constant at $2.95 million per year over the 10-year planning horizon. Administrative costs include the allocation of senior management costs; the remainder of these costs relate directly to the new Motor Vessel division and are paid in cash when due.

• HK requires its customers to make a 15% deposit at the time of order and pay the balance at the time of delivery. The average lag between the time of order and delivery is two months. Sales occur uniformly throughout the year.
• HK has a policy of keeping a cash balance throughout the year equal to 2.5% of expected sales for the year, and an inventory balance throughout the year equal to 25% of expected COGS for the year. The cash balance is essentially funded by the required customer deposits and is invested in marketable securities at an average rate of 0.5%.
• HKs suppliers currently offer terms of 1/10, net 60 on all purchases.

General corporate information

• HKs corporate tax rate is 32%.
• Senior management has determined that 12% is the appropriate discount rate to use in evaluating the proposal to expand its operations to motor vessels.

Appendix
Motor Vessel division, Heavy Keele Ltd. Pro forma operating income statements
					Years 1 to 3		Years 4 to 10
Sales revenue					12,500,000.00		18,000,000.00
Cost of goods sold					(7,000,000.00)		(9,000,000.00)
Gross profit					5,500,000.00		9,000,000.00
General and administrative expenses Depreciation					(2,950,000.00)		(2,950,000.00)
Operatingincome					(1,100,000.00)		(1,100,000.00)
					1,450,000.00		4,950,000.00

Question

Because of the scale of the proposed Motor Vessel division development and the relatively modest returns projected for the division over its first three years, HKs bank has indicated that it intends to raise the interest rate it charges on HKs line of credit from 7% to 8%. Explain whether HK should change its approach to paying its suppliers if the bank raises this rate assuming that HK currently takes advantage of supplier discounts.