Executive Summary
The assignment is about two different case studies which deals with two different situations. The first case study deals with Saturn pet care which is engaged in manufacture of products for pets. The company is trying to expand its business by introducing a new product in the market for which the company has option of selection from two different production sites which are Bathurst site and Wodonga site. The assignment will involve capital budgeting techniques for the purpose of selecting one of the production sites. The second case study deals with ARB ltd which is engaged in manufacturing business for road motors accessories. This part will deal with the analysis of the capital structure of ARB ltd and also comment on the effectiveness of the same.
Part A
Capital Budgeting of Bathurst Site and Wodonga Site
| Capital Budgeting Analysis for Bathurst Site: | |||||||||||
| Years | |||||||||||
| Particulars | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| Initial Investment: | |||||||||||
| Construction on Manufacturing Unit | -$2,75,00,000 | ||||||||||
| Factory Building | -$80,00,000 | ||||||||||
| Infrastructure Grant | $25,00,000 | ||||||||||
| Total Initial Investment | -$3,30,00,000 | ||||||||||
| Operational Cash Flow: | |||||||||||
| Sales Growth Rate | 10% | 10% | 10% | 10% | 10% | 10% | 10% | 10% | 10% | ||
| MAC | 30% | 30% | 30% | 30% | 30% | 30% | 30% | 30% | 30% | 30% | |
| Annual Sales | $3,00,00,000 | $3,30,00,000 | $3,63,00,000 | $3,99,30,000 | $4,39,23,000 | $4,83,15,300 | $5,31,46,830 | $5,84,61,513 | $6,43,07,664 | $7,07,38,431 | |
| Conversion Cost | -$2,10,00,000 | -$2,31,00,000 | -$2,54,10,000 | -$2,79,51,000 | -$3,07,46,100 | -$3,38,20,710 | -$3,72,02,781 | -$4,09,23,059 | -$4,50,15,365 | -$4,95,16,902 | |
| Rebate on Municipal Rate | $5,00,000 | $5,00,000 | $5,00,000 | $5,00,000 | $5,00,000 | $5,00,000 | $5,00,000 | $5,00,000 | $5,00,000 | $5,00,000 | |
| Depreciation on Plant & Equipment | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | |
| Depreciation on Building | -$3,20,000 | -$3,20,000 | -$3,20,000 | -$3,20,000 | -$3,20,000 | -$3,20,000 | -$3,20,000 | -$3,20,000 | -$3,20,000 | -$3,20,000 | |
| Net Profit before Tax | $64,30,000 | $73,30,000 | $83,20,000 | $94,09,000 | $1,06,06,900 | $1,19,24,590 | $1,33,74,049 | $1,49,68,454 | $1,67,22,299 | $1,86,51,529 | |
| Less: Income Tax @ 30% | -$19,29,000 | -$21,99,000 | -$24,96,000 | -$28,22,700 | -$31,82,070 | -$35,77,377 | -$40,12,215 | -$44,90,536 | -$50,16,690 | -$55,95,459 | |
| Net Profit after Tax | $45,01,000 | $51,31,000 | $58,24,000 | $65,86,300 | $74,24,830 | $83,47,213 | $93,61,834 | $1,04,77,918 | $1,17,05,610 | $1,30,56,070 | |
| Add: Depreciation on Plant | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | |
| Add: Depreciation on Building | $3,20,000 | $3,20,000 | $3,20,000 | $3,20,000 | $3,20,000 | $3,20,000 | $3,20,000 | $3,20,000 | $3,20,000 | $3,20,000 | |
| After-Tax Cash Flows | $75,71,000 | $82,01,000 | $88,94,000 | $96,56,300 | $1,04,94,830 | $1,14,17,213 | $1,24,31,834 | $1,35,47,918 | $1,47,75,610 | $1,61,26,070 | |
| Net Cash Flow | -$3,30,00,000 | $75,71,000 | $82,01,000 | $88,94,000 | $96,56,300 | $1,04,94,830 | $1,14,17,213 | $1,24,31,834 | $1,35,47,918 | $1,47,75,610 | $1,61,26,070 |
| Cumulative Cash Flow | -$3,30,00,000 | -$2,54,29,000 | -$1,72,28,000 | -$83,34,000 | $13,22,300 | $1,18,17,130 | $2,32,34,343 | $3,56,66,177 | $4,92,14,095 | $6,39,89,705 | $8,01,15,775 |
| Discount Rate | 22% | 22% | 22% | 22% | 22% | 22% | 22% | 22% | 22% | 22% | 22% |
| Discounted Cash Flow | -$3,30,00,000 | $62,05,738 | $55,09,944 | $48,97,987 | $43,58,845 | $38,83,079 | $34,62,590 | $30,90,412 | $27,60,539 | $24,67,783 | $22,07,650 |
| Payback Period (in years) | 3.863 | ||||||||||
| Net Present Value | $58,44,567 | ||||||||||
| Profitability Index | 1.177 |
Figure 1: (Capital Budgeting of Bathurst Site option)
Source: (Created by Author)
| Capital Budgeting Analysis for Wodonga Site: | |||||||||||
| Years | |||||||||||
| Particulars | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| Initial Investment: | |||||||||||
| Construction on Manufacturing Unit | -$2,75,00,000 | ||||||||||
| Value of Wodonga Site | |||||||||||
| Total Initial Investment | -$2,75,00,000 | ||||||||||
| Operational Cash Flow: | |||||||||||
| Sales Growth Rate | 10% | 10% | 10% | 10% | 10% | 10% | 10% | 10% | 10% | ||
| MAC | 30% | 30% | 30% | 30% | 30% | 30% | 30% | 30% | 30% | 30% | |
| Annual Sales | $3,00,00,000 | $3,30,00,000 | $3,63,00,000 | $3,99,30,000 | $4,39,23,000 | $4,83,15,300 | $5,31,46,830 | $5,84,61,513 | $6,43,07,664 | $7,07,38,431 | |
| Conversion Cost | -$2,10,00,000 | -$2,31,00,000 | -$2,54,10,000 | -$2,79,51,000 | -$3,07,46,100 | -$3,38,20,710 | -$3,72,02,781 | -$4,09,23,059 | -$4,50,15,365 | -$4,95,16,902 | |
| Depreciation on Plant & Equipment | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | -$27,50,000 | |
| Depreciation on Building | $0 | $0 | $0 | $0 | $0 | $0 | $0 | $0 | $0 | $0 | |
| Net Profit before Tax | $62,50,000 | $71,50,000 | $81,40,000 | $92,29,000 | $1,04,26,900 | $1,17,44,590 | $1,31,94,049 | $1,47,88,454 | $1,65,42,299 | $1,84,71,529 | |
| Less: Income Tax @ 30% | -$18,75,000 | -$21,45,000 | -$24,42,000 | -$27,68,700 | -$31,28,070 | -$35,23,377 | -$39,58,215 | -$44,36,536 | -$49,62,690 | -$55,41,459 | |
| Net Profit after Tax | $43,75,000 | $50,05,000 | $56,98,000 | $64,60,300 | $72,98,830 | $82,21,213 | $92,35,834 | $1,03,51,918 | $1,15,79,610 | $1,29,30,070 | |
| Add: Depreciation on Plant | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | $27,50,000 | |
| Add: Depreciation on Building | $0 | $0 | $0 | $0 | $0 | $0 | $0 | $0 | $0 | $0 | |
| After-Tax Cash Flows | $71,25,000 | $77,55,000 | $84,48,000 | $92,10,300 | $1,00,48,830 | $1,09,71,213 | $1,19,85,834 | $1,31,01,918 | $1,43,29,610 | $1,56,80,070 | |
| Net Cash Flow | -$2,75,00,000 | $71,25,000 | $77,55,000 | $84,48,000 | $92,10,300 | $1,00,48,830 | $1,09,71,213 | $1,19,85,834 | $1,31,01,918 | $1,43,29,610 | $1,56,80,070 |
| Cumulative Cash Flow | -$2,75,00,000 | -$2,03,75,000 | -$1,26,20,000 | -$41,72,000 | $50,38,300 | $1,50,87,130 | $2,60,58,343 | $3,80,44,177 | $5,11,46,095 | $6,54,75,705 | $8,11,55,775 |
| Discount Rate | 22% | 22% | 22% | 22% | 22% | 22% | 22% | 22% | 22% | 22% | 22% |
| Discounted Cash Flow | -$2,75,00,000 | $58,40,164 | $52,10,293 | $46,52,372 | $41,57,521 | $37,18,060 | $33,27,328 | $29,79,542 | $26,69,662 | $23,93,293 | $21,46,593 |
| Payback Period (in years) | 3.453 | ||||||||||
| Net Present Value | $95,94,827 | ||||||||||
| Profitability Index | 1.349 |
Figure 2: (Capital Budgeting of Wodonga Site option)
Source: (Created by Author)
The above figure shows that capital budgeting technique application shows the best option available to Saturn pet care for starting the production process is Wodonga site which is clearly shown following all the methods of capital budgeting such as NPV analysis profitability index and payback period analysis (Fauzi, Basyith & Idris, 2013). The NPV method shows that the future cash flow which the business can expect from the production site of Wodonga Site is more than the Bathurst site. The NPV of the Bathurst site is shown in the above figure as $ 58,44,567 which is less than the NPV which is calculated for Wodonga site which is $ 95,94,827. The profitability index shows that for Bathurst site the index is 1.117 which is less than profitability index of Wodonga site which is 1.349. The payback period analysis also shows that Wodonga site is much better option than Bathurst site it allows the business to recover the initial investment amount for the production in less time period. Thus, from above analysis it is clear that the most profitable site for production is Wodonga site.
Product Cannibalization
The term product cannibalization refers to a strategy which is often followed in business where in order to introduce and promote a new product in market, the business reduces the sales of another product (Lin & Kremer, 2014). In the case of Saturn Pet care, it may be very well be possible that the business is using such a technique in order to promote the new product which the management plans to introduce.
Rectifying the Excessive Sales Recorded
As per the question, Nathan who is one of the director of the business is of the view that the marketing department has estimated the sales in excess and therefore the same needs to be rectified so that it does not impact the panning process of the management. The estimation error can be rectified by following NPV method in which the cash outflow estimates can be increased slightly so as to neutralize the estimation error caused previously (Kumar, Sharma & Tewari, 2015).
Inclusion of Original Cost of Old Factory Shed
Nathan also is of the opinion that the original cost of the factory site should be included in initial investment so as to bring about a correct estimate. The judgement of Nathan is incorrect as NPV analysis only takes into consideration the newly developed factory site which has been developed for the production site option.
Part B
Introduction
This part will be dealing with the analysis of the capital structure of ARB Ltd which is engaged in manufacturing business and the effectiveness or weaknesses of the capital structure is to be identified. In coming paragraphs, detailed analysis of capital structure and it changes over the years have been conducted.
Capital Structure and Cost of Capital
The capital structure of ARB Ltd shows that the company only employs equity share capital in the capital mix which is used by the company (Barth, Konchitchki & Landsman, 2013). The company does not employ any debt capital in the capital mix and the capital structure of the business is solely comprised of equity capital. The present capital structure of the company is shown ion the table below:
| CURRENT CAPITAL STRUCTURE: | ||
| Particulars | Amount | Weightage |
| (in ‘000s) | ||
| Total Equity | $2,72,341 | 100% |
| Secured Borrowings | $0 | 0% |
| TOTAL CAPITAL | $2,72,341 | 100% |
Weighted Average Cost of Capital
The weighted average cost of capital for the company as revealed by the computation reveals that the WACC of the company comes to 18.05%. WACC is the average of all cost of capital from different sources of finances which are employed by the business. The overall cost of capital has reduced from previous year’s estimates which shows that the cost of financing has somewhat reduced which is a positive sign (Frank & Shen, 2016). The WACC for 2016 was 19.01% which has reduced to 18.05% in 2017.
| WACC: | ||||
| Particulars | 2017 | 2016 | 2015 | 2014 |
| (in ‘000s) | (in ‘000s) | (in ‘000s) | (in ‘000s) | |
| Net profit after Tax | $49,152 | $47,439 | $44,093 | $42,570 |
| Total Equity | $2,72,341 | $2,49,608 | $2,26,348 | $1,97,814 |
| Cost of Equity | 18.05% | 19.01% | 19.48% | 21.52% |
| Weightage of Equity | 100.00% | 100.00% | 99.12% | 100.00% |
| Interest Expenses for secured borrowings | 0 | 0 | 220 | 0 |
| Secured Borrowings | $0 | $0 | $2,000 | $0 |
| Cost of Debt | 0% | 0% | 11.00% | 0% |
| Weightage of Debt | 0% | 0% | 1% | 0% |
| Tax Rate | 30% | 30% | 30% | 30% |
| WACC | 18.05% | 19.01% | 19.39% | 21.52% |
Cost of Capital Under CAPM
The cost capital when computed under CAPM approach considers a number of variable such as risk-free rate of return, market rate of return and Beta which is the risk factor (Johnstone, 2016). The cost of equity as per CAPM approach is computed to be 7,906% which is favorable considering the market rate of return which is 8.54%. This signifies that the expectations of the shareholders are meet.
| Cost of Equity under CAPM: | |
| Particulars | Amount |
| Beta | 0.89 |
| Market Return | 8.54% |
| Risk Free Rate | 2.78% |
| Expected Cost of Equity | 7.906% |
Comparison between ARB ltd and Modine ltd
For the purpose of Comparison, Modine ltd which is engaged in same industry and has similar operation as ARB ltd is selected. The capital structure of Modine ltd is made up of both equity and debt capital. This shows that the business is trying to achieve a favorable capital mix which can reduce the overall risks of the business. In case of ARB Ltd, the capital structure is only made up of equity share capital. The equity and debt capital which is used by Modine ltd is shown at $ 421.20 million and 519.90 million respectively. This shows that Modine Ltd has a better capital structure as compared to ARB ltd.
| COMPARISON with MODINE MANUFACTURING COMPANY | ||||
| ARB | MODINE | |||
| Particulars | Amount | Weightage | Amount | Weightage |
| (in ‘000s) | (in million) | |||
| Total Equity | $2,72,341 | 100% | $421.20 | 45% |
| Secured Borrowings: | ||||
| Short Term Debt | $73.4 | |||
| Current Portion of Long Term Debt | $31.8 | |||
| Long Term Debt | $405.7 | |||
| Total Secured Borrowings | $0 | 0% | $510.90 | 55% |
| TOTAL CAPITAL | $2,72,341 | 100% | $932 | 100% |
Financial Ratios of ARB Ltd
The financial ratio of the company depicts profitability, solvency and efficiency ratio as shown in the figure shown below (Pervan & Kuvek, 2013). The current ratio of the company as shown in the table below has increased from previous year estimate which shows that the liquidity position of the company has improved (Kohansal et al., 2013). Another significant ratio which is needed to be considered is debt equity ratio which has increased from previous year suggesting rise in debts. Another positive is inventory turnover ratio which has increased from previous year as well which is a positive sign.
| Profitability Ratios | ||||
| Particulars | 2017 | 2016 | 2014 | 2015 |
| Total Revenue | 382599 | 356905 | 329755 | 297779 |
| Materials & Consumables Used | 173600 | 161857 | 149646 | 131764 |
| Net Profit | 49152 | 47439 | 44093 | 42570 |
| Total Assets | 323243 | 291808 | 269869 | 241764 |
| Total equity | 272341 | 249608 | 226348 | 197814 |
| Gross Profit Margin | 0.454 | 0.454 | 0.454 | 0.442 |
| Net Profit Margin | 0.128 | 0.133 | 0.134 | 0.143 |
| Return on Assets | 0.152 | 0.163 | 0.163 | 0.176 |
| Return on Equity | 0.180 | 0.190 | 0.195 | 0.215 |
| Solvency Ratio | ||||
| Particulars | 2017 | 2016 | 2014 | 2015 |
| Total Assets | 323243 | 291808 | 269869 | 241764 |
| Total equity | 272341 | 249608 | 226348 | 197814 |
| Total Liabilities | 50902 | 42200 | 43521 | 43950 |
| Current Assets | 169177 | 148466 | 133820 | 150620 |
| Current Liabilities | 49785 | 40944 | 42544 | 43230 |
| Finance Costs | 11 | 170 | 220 | 0 |
| Operating Profit | 67512 | 64549 | 60236 | 57291 |
| Current Ratio | 3.398 | 3.626 | 3.145 | 3.484 |
| Time Interest Earned Ratio | 6137.455 | 379.700 | 273.800 | |
| Debt-to-Equity Ratio | 0.187 | 0.169 | 0.192 | 0.222 |
| Debt Ratio | 0.157 | 0.145 | 0.161 | 0.182 |
| Equity Ratio | 0.843 | 0.855 | 0.839 | 0.818 |
| Efficiency Ratio | ||||
| Particulars | 2017 | 2016 | 2014 | 2015 |
| Inventory | 88020 | 86941 | 77821 | 70443 |
| Trade Receivables | 50840 | 44425 | 42216 | 39762 |
| Trade Payables | 35279 | 27754 | 28874 | 30202 |
| Cost of Goods Sold | 173600 | 161857 | 149646 | 131764 |
| Sales Revenue | 382599 | 356905 | 329755 | 297779 |
| Inventory Turnover Ratio | 1.972 | 1.862 | 1.923 | 1.871 |
| Payables Turnover Ratio | 4.921 | 5.832 | 5.183 | 4.363 |
| Receivables Turnover Ratio | 7.526 | 8.034 | 7.811 | 7.489 |
Changes in capital structure
The capital structure has changes over the years which is evident from the table which is shown below. In current scenario the business only uses equity capital mix in the capital structure of the business.
| CHANGE in CAPITAL STRUCTURE: | ||||||||
| 2017 | 2016 | 2015 | 2014 | |||||
| Particulars | Amount | Weightage | Amount | Weightage | Amount | Weightage | Amount | Weightage |
| (in ‘000s) | (in ‘000s) | (in ‘000s) | (in ‘000s) | |||||
| Total Equity | $2,72,341 | 100% | $2,49,608 | 100% | $2,26,348 | 99% | $1,97,814 | 100% |
| Secured Borrowings | $0 | 0% | $0 | 0% | $2,000 | 1% | $0 | 0% |
| TOTAL CAPITAL | $2,72,341 | 100% | $2,49,608 | 100% | $2,28,348 | 100% | $1,97,814 | 100% |
| Change in Total Capital | 9.11% | 9.31% | 15.44% |
Wealth Maximization
The company has not been able to achieve the growth which the company has expected to achieve. Even though the NOPAT of the business has increased slightly, the company needs to put more focus on wealth maximization principle (Fernandez, 2015).
| SHAREHOLDER’S WEALTH: | ||||
| 2017 | 2016 | 2015 | 2014 | |
| Particulars | Amount | Amount | Amount | Amount |
| (in ‘000s) | (in ‘000s) | (in ‘000s) | (in ‘000s) | |
| NOPAT | $49,152 | $47,439 | $44,313 | $42,570 |
| Total Capital Employed | $2,72,341 | $2,49,608 | $2,28,348 | $1,97,814 |
| WACC | 18.05% | 19.01% | 19.39% | 21.52% |
| Total Capital Cost | $49,152 | $47,439 | $44,269 | $42,570 |
| Economic Value Added | $0 | $0 | $44 | $0 |
Recommendations and Conclusion
The recommendation which can be suggested to ARB Ltd are given below in points:
Thus, it is clear that ARB Ltd needs to improve the capital structure of the company by adding debt capital and attaining a balance which in turn can reduce the risk associated with capitals efficiently. The company also needs to maximize the wealth of the shareholders of the business.
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