How to Proceed

1. Review the information and financial statements included below to gain an understanding of potential investment initiatives that would be supportable by management. Describe the intent of the mission statement from the annual report, and prepare a SWOT analysis (strengths, weaknesses, opportunities, threats). Based on your SWOT analysis, assess and explain in detail if Pear Computer Horizons currently delivering on its mission statement.
2. Conduct financial statement analysis using liquidity ratios, debt ratios, profitability, and asset utilization ratios (at least three for each type of ratio). Comment on each of the ratios and what they say about the companys performance over the last 5 years.
3. Prepare an assessment for each of the investment proposals included below, with a rationale that is aligned with the SWOT analysis and financial statement ratio analysis. Recommend if PCH should go forward with any of the proposed investments based on this analysis.
4. Prepare a basic income statement forecast for the subsequent fiscal year, using a percentage of sales approach and using information included in the materials below to support assumptions that correspond for each revenue and expense. Each line item (e.g., marketing expenses) should have a note and an explanation on how it was calculated.
5. The CEO also needs help understanding the tax consequences of the disposal of some manufacturing equipment. Prepare a CCA schedule for tax depreciation of manufacturing equipment purchased three years ago on January 1, 2015 for $340,000 (assume Class 46 with CCA rate of 30% and half-year rule applying). Calculate the tax consequence if all the equipment were to be sold at the beginning of this year (i.e., end of 2017) for either $120,000 or $160,000. The equipment is the only asset in the class. Utilize the average tax rate that Pear Computer Horizons had in the last five years in your analysis of the tax impact.

Pear Computer Horizons Case Study

Company Background

Pear Computer Horizons (PCH) started out as the brainchild of several engineers in the eighties, with the founding team working out of a garage in Winnipeg, Manitoba. The company originally focused on creating easy-to-assemble hardware (e.g., desktop computers) that the average Canadian could afford. Over time, as computers became the part of everyday life, PCH branched out into several different models and tiers.

In the mid 2000s, the company went on a large acquisition spree, acquiring several software companies and mobile manufacturing start-ups, allowing the once hardware-only company to diversify into phones, software, and gaming (both video game consoles, as well as game development). The business was reorganized into three segments in 2010. The first segment, computers, focuses on manufacturing computer chips, laptops, desktop computers, and computer accessories. The second segment, phones, was once the smallest business division, but has rapidly grown into the number one segment by total sales in 2017. The third major segment, software and gaming, includes games for computers and video game consoles, as well as anti-virus, word-processing, and analytics software.

PCH products are sold across Canada in various retail stores, as well as through their high-traffic e-commerce site. PCH manages shop-in-shops in electronic stores like Best Buy; specialized areas in big department or electronic stores that only sell PCH products. Products have also expanded in recent years into the US, but market share is low. There are future plans to expand into Latin America and India, two developing economies that do not have as much technology penetration as other more mature markets.

The companys mission statement, extracted from their 2017 annual report, is included below:

Pear Computer Horizons strives to be the technological choice for people, businesses, and governments for their innovation, entertainment and security needs.

The company is publicly traded under the ticker PCH.TO on the Toronto Stock Exchange, and has been paying a steady dividend over the last ten years.

Discussion with Chief Executive Officer (CEO)

Ms. Morrison, CEO, has reached out to you to help her assess the current financial and strategic state of Pear Computer Horizons, evaluate some investment proposals, build a financial forecast for 2018, and evaluate tax consequences of an asset disposal.

The last five years have been a wild ride, exclaimed Ms. Morrison, who has risen through the ranks to the top position after 15 years in the company. We have almost tripled our revenue in the last five years, in large part to some big product launches in gaming and phones that were more successful than we ever imagined. We also benefited from the booming tech industry that continues to see large technological advances in a short period of time.

However, now is not the time to get complacent, continued Ms. Morrison. We successfully grew in the past through mergers & acquisitions, and we will continue to be on the lookout to snatch any smaller tech companies making noise with innovative ideas. This growth is especially critical in the phone and gaming & software segments, which have seen increasing competition in Canada.

We are also facing increasing government regulation relating to customer data, its storage, and its use, especially since we have access to confidential information through our security software. Furthermore, because we possess this information, we are facing more cyber-attacks and data security threats. Thankfully, we have not had any significant breaches yet, but the threat remains. Any serious breach could harm our reputation, as well as our stock price.

Qualitative & Quantitative Analysis

To help with your assessment of PCHs current state and the investment proposals, Ms. Morrison recommends that you develop a SWOT analysis and also perform financial statement analysis.

SWOT stands for strengths, weaknesses, opportunities, and threats, explained Ms. Morrison. It is a standard tool used in internal and external assessment, with a focus on qualitative factors. Strengths are things that a company does well, while weaknesses are areas of improvement. Strengths and weaknesses are internal to the firm, meaning that PCH can have substantial control over them. Opportunities and threats are external to PCH, meaning that these are environmental changes that are outside of our control, but could be working for or against our favour. Government regulation is an example of an externality that could be an opportunity or a threat, depending on your business or point of view.

Financial statement analysis involves the use of ratios to evaluate the performance, financial health, and efficiency of a company, among other things, continued Ms. Morrison. I would like you to analyze the liquidity, profitability, efficiency (asset utilization), and solvency (debt ratios) of PCH, and to fully explain what the trend in these ratios are indicating about my companys historical performance. Ratios can be used to tell a storywhat story do you see coming from the numbers?

Financial Forecast

Ms. Morrison has asked for your help in developing a financial forecast for 2018, using the 2017 income statement as a reference point.

2018 is expected to see a reduction in the rapid growth rate that PCH experienced over the last five years, as total sales are only expected to increase by 10% in 2018. Customers have started hanging on to their older versions of phones, as there has been some customer dissatisfaction with newer mobile models, because they were not offering a unique enough position to warrant an upgrade. For example, the slim smartphone the Pearcer, which was 2016s best-selling smartphone, had lower-than expected sales for the third version, the Pearcer 3.0. The phone segment is expected to be 50% of total 2018 sales, down from 51.7% in 2017.

Computers will maintain a similar share as a percentage of sales as in 2017, while the gaming & software segment is expected to increase to 17% of sales, due to the launch of the newest version of InPEARmeable antivirus software and the sequel to the best-selling video game Eternity. Ms. Morrison wants your forecast to include the dollar amount of sales that each segment should generate in 2018.

Our company is dependent on big product launches for success, lamented Ms. Morrison. These gambles often payoff, but they require thousands of man hours and millions of dollars. We have not had any major setbacks, like some of our competitors, but the risk is always there. Our last three major product releases had countless delays that frustrated some of our core customers. It did build up anticipation for our products in the end, but we will not always come out on top from poor planning. I want us to mitigate some of the risk with smaller projects that have the potential to give a high return. Similar to how movie production studios counter their big budget box office movies with lower-budget dramas and horror films that may offer a higher return on investment.

Historically, PCH had some of the highest gross margins in the industry, due, in large part, to the cutting edge technology incorporated in most of the products. PCH has focused mostly on the consumer segment, thanks to the larger margins, but is considering long-term partnerships with governments and universities, despite their lower margins, in order to stabilize a long-term revenue source.

However, several macro and micro factors are expected to influence gross margins for 2018. Material costs for aluminum, a key component in PCH computers, are expected to rise significantly in 2018, negatively impacting gross margin by 2%. The depreciating Canadian dollar relative to other currencies is also expected to negatively impact gross margin by -1%. PCH is switching to a more ethical supplier for some of its component parts, due to bad press in 2017 over this suppliers reported environmental violations. This change will lead to a 1% increase in the cost of goods sold. Finally, there is major uncertainty surrounding NAFTA and trade tariffs at the US border. Ms. Morrison suggests, as a conservative estimate, to include a 1% reduction in gross margin to incorporate this uncertainty. Taking all the aforementioned factors into account will help forecast what the expected 2018 gross margin is for PCH.

Advertising and marketing and also general and administrative (G&A) costs are expected to remain at the same percentage of sales as in the past. PCH lacks a strong advertising and marketing strategy, despite its large advertising budget, because the head of marketing left at the beginning of 2017 for medical reasons. G&A costs will be impacted by minimum wage increases, but those are not expected to take effect into 2019. PCH has managed to keep employee turnover low, despite minimum wages, due to its employee profit-sharing and stock ownership plan.

Research and development (R&D) costs have traditionally been budgeted as 20% of computer sales, because the companys superior R&D capability has been a competitive advantage. This advantage has helped attract some of the top talent in the country. Unfortunately, PCHs purchase of a virtual reality company a few years back was not as fruitful as anticipated. The virtual reality company was absorbed as a sub-division of the company, but it is now being divested to cut down on costs, leading to an expected $100M loss in 2018 from a write down of goodwill. Equipment and licenses from that division are also being sold, with a $20M gain from the license sale mitigated by a $10M loss from the equipment sale.

The tax rate, depreciation, and interest rate for PCH are expected to be consistent with prior years. PCHs long-term debt consists of ten-year bonds that do not mature into 2023. PCH also has a credit facility with $300M borrowing capacity that had no outstanding borrowings at the end of the fiscal year.

Investment Proposals

Ms. Morrison wants you to assess two investment proposals that the PCH investment team is considering.

Ms. Morrison is considering purchasing a small, but cutting-edge, Canadian camera company that is developing high-quality cameras for mobile phones. While only at the prototype stage, the initial tests have been positive, with the cameras pixel quality and image resolution rated almost four times better than the leading mobile product currently on the market. The company has had difficulty with battery life and software, which is why it is seeking a strategic buyer with the capability to improve on the current iterations of its products. Ms. Morrison is wondering if the company should pursue another acquisition so soon after the failure of the virtual reality sub-division, and she is worried about the ability of PCH to fund this purchase after the $100M loss.

Ms. Morrison is also considering the launch of a new laptop and associated software specifically designed for governments and universities, with a focus on security provided for confidential network information. There has been a lot of interest from India and Latin America in a multi-year deal, as well from underpenetrated parts of the US. Development on the project is still in the works after several delays, and PCH would have to take on a significant amount of inventory in the initial stages. Ms. Morrison has to make the final call on continuing the project or shifting funds away to some newer projects that could have more financial promise.

Ms. Morrison wants you to assess how these two proposals align with the strategy of PCH, using your SWOT analysis and ratio analysis, and ultimately to make a recommendation whether to accept none, one, or both of the proposals.

Tax Assessment

Finally, Ms. Morrison has one last requestshe needs help understanding the tax consequences of the disposal of some old equipment. Prepare a CCA schedule for tax depreciation of equipment purchased three years ago on January 1, 2015 for $340,000 (assume Class 46 with CCA rate of 30% and half-year rule applying). Calculate the tax consequence if all the equipment were to be sold at the beginning of this year (i.e., end of 2017) for either $120,000 or $160,000. The equipment is the only asset in the class. Utilize the average tax rate that PCH had in the last five years in your analysis of the tax impact.

Financial Statements