Financial Management Assignment: Case Analysis Of AL Pty Ltd

Question

Task:
Summary
Write a 2,500-word report based on the provided context scenario and financial information. Analyse two options proposed by the management team of the case study company to maximise its value. Conduct the necessary financial analysis using the information provided and using appropriate techniques, tools and frameworks. Make decisions and recommendations based on the analysis and consider all relevant implications, challenges and limitations.

Financial Management Assignment Task

Context
Assessment 2 follows on from the financial review of Amazing Lounge Pty Ltd (AL Pty Ltd) undertaken in Assessment 1.

AL's management team have brainstormed two options with the objective of maximising AL’s value. Being part of the management team, you have been asked to investigate the possibility of different options. The two options A and B are outlined below.

Option A: Invest in a new product
AL Pty Ltd, is planning to introduce a new model of lounge shortly. The new machinery required to manufacture the new model costs $20,000,000 and has a useful life of 5 years. The machine will be depreciated during these years as per the straight-line method. The machine will have no scrap value at the end of its life. AL Pty Ltd has done the market research and estimated to sell 10,000 units of the new model at the selling price of $4,200 per unit. Each unit will cost $2,500 to produce. This will also require an additional working capital in the beginning year 1 of $2,000,000 which will be recovered in year 5.

For option A, you are provided with the incremental financial information in the table below.

To evaluate the above project, utilise the capital budgeting techniques that you have studied in this subject. For this purpose, the finance analyst recommended a 10% required rate of return.

Option B: Outsource the current manufacturing plant overseas
AL Pty Ltd is investigating an opportunity to relocate its manufacturing plant to another country to manufacture the current model of lounge. Through the outsourcing program, it is expected that the unit variable cost will be reduced by $100, and the total cash fixed cost will drop by $3,000,000. The cost reduction will be achieved through access to cheap labour and different material composition. AL's current cost structure per annum (pre-outsourcing) is given in the table below:

Number of units produced per annum

20,000

Sales price per unit

$1,000

Variable cost per unit

$400

Total cash fixed cost per annum

$10,000,000

Total depreciation per annum

$4,000,000

You have been asked to assess the above plan and present your recommendations.

Print version: financial information for Option A & Option B

Written Report
Write a report for the management team that addresses points 1 to 4 below:

Complete a financial evaluation of Option A using both NPV and simple Payback Period (not the discounted payback) capital budgeting techniques. Discuss which one is better and why. Use the payback cut-off period of 2 years for the evaluation, and use 10% as the discount rate to calculate the NPV. In assessing Option A, your report should also consider a sensitivity analysis on the NPV for the discount rate changing from 10% to 15%. Investing in a new product can be classed as a ‘risky investment’. How can the risk-return principle be applied here and, from a financial modelling point of view, how can the risks of the project be analysed?

Complete a critical assessment of Option B using break-even analysis. Calculate and evaluate the current accounting and cash break-even points of the business. Your analysis of Option B should then include the revised break-even points (both cash and accounting break-even points) considering the outsourcing option. Based on market research, you anticipate sales with the new outsourcing option to remain the same at 20,000 units. Comment on the financial and non-financial implications of Option B.

A further idea briefly discussed by the AL executive team (but not as an option) was to extend the payment terms for customers from 30 days to 60 days. What are the implications of increasing the payment terms of customers to the cash cycle? Discuss possible scenarios where providing an extended payment term can benefit AL Pty Ltd.

Based on your analysis covered in points 1 and 2 recommend either Option A or Option B, or both to the AL management team. Your recommendation should also include a detailed limitations section covering the challenges of using NPV, Payback Period and break-even points in the decision making.

Answer

Introduction
According to the investigation on financial management assignment, the concept of financial management is defined as the strategic process of planning, organising, directing and controlling financial activities in the organisation. It involves the application of adequate management principles to the financial assets of the business that plays the decision-making role in fiscal management. As opined by Madura (2020), financial management provides a gateway to recover the organisational goals and objectives in the business. The main role of a financial manager is to measure the organisational efficiency and effectiveness by means of proper allocation, acquisition of assets and management of resources. Financial management helps in making financial decisions, investment decisions and dividend decisions of the business.

1. Conduct the financial evaluation of Option A
Option A

The calculation above shows the financial evaluation of Option A for AL Pty Ltd using NPV and a simple Payback Period. The NPV depicted the results as $623675593.4 at the end of 5 years for a discounting rate of 10%. According to the decision criterion of NPV, Option A stands to be feasible for the entity as the NPV is positive or more than 1. A positive NPV suggests that cash inflow is greater than the cash outflow or the initial cost of investment, and hence it is feasible. The initial cost of investment is $22000000, whereas the NPV is $623675593.4, indicating a higher cash flow for Option A and, therefore, is positive as well as feasible.

The payback period for Option A is 0 years. This means by the commencement of Year 1, and AL Pty Ltd shall receive back its initial cost of investment which is $22000000. The cut-off period of the payback period decided by the company is 2 years for the evaluation. According to the payback period principles, the actual payback period should is less or equal to the cut-off period for the project to be feasible for the entity (Loke, 2017). In the given case, the calculated payback period is lower (0 years) than the cut-off period (2 years). Hence, Option A is feasible for the business.

Between NPV and Payback Period, NPV is a better capital budgeting method than other methods, as NPV uses the concept of discounted cash flows to analyse the favourable attribute of the business. This makes NPV more precise than the Payback Period as it considers both risk and time variables. NPV allows the business managers to make better decisions in comparison to the payback period while making a capital investment, as relying solely on the payback method might result in taking poor financial decisions (Masharsky et al., 2018). In most organisations like AL Pty Ltd, both methods are used simultaneously to make optimal investment and financing decisions. While discussing the advantages, the payback period is the simplest method of capital budgeting and easier to compute for small, repetitive investments and factors like tax and depreciation rates.

On the other hand, NPV is the most accurate and efficient method to measure the cash flows and not profits and these results in investment decisions giving more added value. Considering the disadvantages, NPV assumes that there will be a constant discount rate over the entire life of the investment and, therefore, limited in making a prediction of future cash flows (Yap et al., 2018). The cons of the payback period involve that it does not take into consideration of the cash flows and profits after deriving the payback period. Moreover, it ignores the money value and financial risks prior to or during the investment.

Sensitivity Analysis

Sensitivity analysis is the financial model that is computed to determine how the target variables are influenced based on the changes in the other related variables known as the input variables (Brighamand Houston, 2021). A sensitivity analysis on the NPV is conducted for AL Pty Ltd by bringing a change in the discounting rate from 10% to 15%. It can be observed that at a 10% discounting rate, the NPV is $623675593.4, whereas, at a 15% discounting rate, the NPV is $548860720.1. It marks a difference of $74814873.3 of NPV. This is due to an increase in the discounting rate leading to a downfall of NPV. There is an inverse relationship between the NPV and discount rate. A higher discount place gives more priority to the earlier cash flows, which are generally the cash outflows. In case the value of outflow is more than inflows, the NPV is negative.

The investment principle states the risk-return tradeoff indicates that the higher the risk, the higher is the potential to secure reward in the form of return. Investors take into account the risk-return tradeoff for an individual investment portfolio to make investment decisions. For AL Pty Ltd, investing in a new product shall be classified as a risky investment decision as the company needs to prosper on its existing product line rather than investing in new products (Prihartonoand Asandimitra, 2018). The risk shall be applied here in the decrease of the sales price per unit of the company for the new products. The demand for the new products may not be large, therefore, hampering the overall sales revenue of the business. With a view to secure more revenue and profit by the company from the new products, the company may lose out on its customers by offering products that are not demanded.

2. Critical assessment of Option B using break-even analysis
Before outsourcing
Break-even analysis (in cash basis) = Fixed Costs- Non-cash expenses/ Selling price per unit- Variable cost per unit

= 10000000-400000/1000-400

= 6000000/600

= 10000 units

Break-even analysis (in accounting basis) = Fixed Costs / Selling price per unit- Variable cost per unit

= 10000000/1000-400

= 10000000/600

= 16667 units

Option B is related to outsourcing of current manufacturing plant in the foreign country by AL Pty Limited. Prior to outsourcing decisions, the BEP is calculated both for cash basis and accounting basis. According to the cash basis, the break-even point for the manufacturing plant is 10000 units. This means the company needs to sell at least 10000 units to surpass the loss-making situation. Any unit beyond 10000 units shall be considered as profit for AL Pty Limited. A cash break-even analysis implements the equation that involves the removal of non-cash expenses like depreciation (Ameliawatiand Setiyani, 2018). It causes a difference in the result and provides the business analysts with a greater insight into the financial condition of the entity.

In the given case, the BEP is 10000 units that show the minimum amount of sales that are required by AL Pty Ltd with positive cash flows.

This method is undertaken by the business as AL Pty Ltd has limited availability of cash. Moreover, holding excess cash requires AL Pty Limited to pass on alternative opportunities that are more beneficial, which costs the business money in losing out opportunities if it decides to hold onto the cash. In the second case, the BEP is computed on an accounting basis. It delivered a result of 16667 units. This means, at the sales level of 16667 units, AL Pty Ltd shall generate exactly zero profits at the respective fixed costs. This method of BEP assumes that the business follows the accrual basis of accounting; therefore, the portion of the fixed costs of the calculation includes all expenses- both cash expenses and non-cash expenses under the accrual basis of accounting (Chang et al., 2020). It can be observed that a higher proportion of BEP is recorded for an accounting basis, as it includes the depreciation expense within the computation of break-even units.

After outsourcing
Break-even analysis (in cash basis) = Fixed Costs- Non-cash expenses/ Selling price per unit- Variable cost per unit

= 7000000-400000/1000-300

= 3000000/700

= 4286 units

Break-even analysis (in accounting basis) = Fixed Costs / Selling price per unit- Variable cost per unit

= 7000000/1000-300

= 7000000/700

= 10000 units

After taking into account the outsourcing decision to another country to manufacturing the present model of lounge, it is anticipated that the variable cost shall decrease to $300, and the total fixed cost shall drop to $7000000. Again, BEP for both cash method and accrual method are computed and derived results of 4286 units and 10000 units, respectively. It can be observed that there has been a fall in the BEP for both cases after considering the outsourcing decisions. According to the principles of break-even point, a lower BEP level in units is said to be more favourable. A low BEP means that the business can start making profits earlier in comparison to high BEP (Bulturbayevichet al., 2020). Therefore, AL Pty Ltd must outsource its manufacturing unit to a foreign land to derive lower BEP and, therefore, earn quick profits.

The non-financial implications of Option B state that-
Satisfied stakeholders: A faster and quicker profit earned by AL Pty Ltd shall enable the company to make high returns to its shareholders in the form of dividends and interests. This will enable the stakeholders to be satisfied and engaged with the project for a long-term basis.

Increased brand awareness: Overseas venture of AL Pty shall allow the company to mark prominence in the international market. This shall leverage the company to engage more customers and draw in more demand for lounge making businesses.

3. Discussion of possible scenarios to extend payment terms
With an extension in the credit period to the buyers of AL Pty Ltd for their purchases, the company shall be able to increase its sales and expand the universe for the buyer. This shall enable the company to meet the sales target of the entity by increasing the due time. The existing credit period is 30 days for the customers to make payment which is decided to extend to 60 days for the customers. This shall mean instead of a month; the customers shall have a time period of 2 months to make payment of their dues against the credit sales. The following the pros that AL Pty Ltd shall experience from the extension of payment terms are-

Increased sales: The customers of AL Pty Ltd shall tend to purchase more if they do not have to pay for the goods and services immediately (Mashud et al., 2020). This indicates higher sales that result in high profit for the business.

Competitive edge: Extension of credit to the customers will allow the customers to add on the competitors who do not extend the payment period to their customers. Customers may be encouraged to do business with AL Pty Ltd against the competitors that do not extend credit to their customers.

Customer loyalty: Over the period of time, the customers of AL Pty Ltd shall build trust with the customer to provide them with products and services as they need without having the liability to pay upfront (Disemadiand Shaleh, 2020). This allows the customers to build a long-term and profitable relationship with the customers for the upcoming years.

4. Recommendation
Based on the analysis undertaken in points 1 and 2 about the investment project in AL Pty Limited, it is recommended to consider both Option A and Option B simultaneously for the company. In both scenarios, Option A offers a positive of $ 623675593.4, and Option B instructs the company to outsource its manufacturing unit to a foreign land. Implementation of both the cases shall derive the company with financial benefit from the investment decision. However, there are following disadvantages that AL Pty Ltd shall suffer from the use of both the options-

Disadvantages of NPV
The biggest disadvantage of NPV is that it requires some assumptions about the company's cost of capital. It requires the assumption of the cost of capital, and if it is too low will result in making sub-optimal investments (Singh et al., 2021). On the other hand, an assumption of the cost of capital of too high will result in foregoing too favourable a good investment. Moreover, the NPV method is not favourable in comparing two capital projects of various sizes. As the results derived from the NPV method is in $, the size of NPV out is determined usually by the size of the input.

Disadvantages of Payback Period
The disadvantage of the payback period is that it ignores the time value of money. The cash flows that are received during the early years of the capital project carry higher weightage than those of the later years. The payback period neglects the cash flows that are received after the payback period. For few projects, the largest cash flow may be available until the end of the payback period. Such projects could acquire a higher return on investment and may be more favourable to the projects that acquire a shorter payback period.

Disadvantages of Break-even point
There are multiple disadvantages of break-even point-

• It assumes that sales prices are fixed at all levels of the output
• It assumes the production and sales at the same level
• The break-even charts are time consuming to make
• It is applicable to single products

Conclusion
It can be concluded that financial management facilitates the business in making decisions for the entity. It takes into account various financial management tools to make optimal decisions for the business. Regular activities of financial activities may be difficult for managers; however, the financial management activities help the companies to run efficient businesses. The functions involved in financial management involves record-keeping, financial reporting and rising of funds to help the business reaching to financial success. Solvency is a key factor of financial management for the repayment of the loan in maintaining the strong balance sheet performance.

Reference List
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Chang, C.L., McAleer, M. and Wong, W.K., 2020.Risk and financial management of COVID-19 in business, economics and finance.https://www.mdpi.com/721044

Ameliawati, M. and Setiyani, R., 2018.The influence of financial attitude, financial socialisation, and financial experience to financial management behavior with financial literacy as the mediation variable. KnE Social Sciences, pp.811-832.https://www.knepublishing.com/index.php/KnE-Social/article/view/3174

Prihartono, M.R.D. and Asandimitra, N., 2018. Analysis factors influencing financial management behaviour. International Journal of Academic Research in Business and Social Sciences, 8(8), pp.308-326.https://www.researchgate.net/profile/Nadia-Asandimitra/publication/334243518_Analysis_Factors_Influencing_Financial_Management_Behaviour/links/ 5dff62f7a6fdcc28373597b0/Analysis-Factors-Influencing-Financial-Management-Behaviour.pdf

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