Mr inherited 20,00,000 from his uncle. He puts all the money into his new business, Limited, which starts to generate yearly revenue of 25,00,000 and earns him an operating profit of 3,00,000 per annum leading to a 15% return on assets. Mr was happy to see the return on his asset go up from 3% to 15% and was satisfied with it. JGBS continued to distribute all the earnings from the business as dividends because Mr was able to generate the same 15% return through other investments outside of the business and believed that the diversification reduced his risk. However, the business faced a downturn as the economy slowed down. Mr realizes that JGBS return on assets reduced sharply from 15% to 12% when revenue fell marginally to 24,00,000. He did not like the sharp decline in his dividend earnings and wanted to understand the cause so that he could fix it. He consulted with BBA Consultants. They advised that JGBS has a very high fixed cost. If JGBS wanted to reduce exposure to a decline in sales it needed to change the operating model to make more of its costs variable. However, the economy revived quickly and JGBS improved its performance back to revenue of 25,00,000 and a 15% return on assets. JGBS buyer expanded its business and wanted JGBS to add capacity to meet the increased requirement. It was decided that JGBS will buy more efficient machinery even though it would cost more. The total cost of the new factory would be 25,00,000. It would generate an improved operating profit margin of 13.5% (the operating profit margin of the old factory was only 3,00,000 / 25,00,000 = 12%) but the return on assets would drop to 13.5% due to the higher capital expenditure for efficient technology. Mr liked the plan for the new factory because it would make JGBS a market leader for its product and improve its competitiveness. And given JGBS's track record of running this business successfully, he felt very comfortable with the operational aspects of the new factory. Since JGBS was fully owned by Mr JGU and had never taken debt, it was assumed that Mr would fund the new factory through fresh equity into JGBS. When Mr reviewed his personal finances he realised that he could not fund all of the 25,00,000 required to execute the project. The CFO of JGBS then hired BBA Consultants for help. BBA Consultants advised JGBS that they can raise debt from a bank to fund part of the new factory. Given the successful track record of JGBS first factory, the CFO was able to get the bank to agree to lend 15,00,000 for the second factory at 7.75% p.a. to be compounded monthly but payable annually. The bank was to be repaid at the end of 10 years. The bank also required that JGBS raise equity for the remaining cost of the project. Mr was able to provide the remaining cost of the project. However, before proceeding with the second factory, Mr JGU was unhappy about his own returns. He had been earning 15% on his capital in the first factory and would like to earn the same return on his investment in the second factory. He was disheartened to note that the second factory would only generate a return on assets of 13.5%.

5. Is he correct in being disheartened? If you are part of BBA Consultants, what explanation and advice would you give him? [3]