Lifestyle Furniture

Question: Describe about the Lifestyle Furniture. Answer: Background Lifestyle Furniture is one of the leading vendors of hardwood furniture. The Company founder and CEO, Mr Fred Smith has run the company well and it has generated a cumulative sales turnover of over $13 million with profits in excess of $1.75 million till 2015. To continue growth, the company has two choices to make 1. Renew an existing machine which costs $ 135,000 and will be usable for 5 years before being scrapped. Sales are expected to grow @ 13.5 % pa after the first year sales of $ 800,000. There are costs associated with operations, maintenance, consultant cost and other costs of salary overheads. Overall, the net cash flow of the option for the 5 years is $ 29,421 2. Buy new craft machine and sell the existing machine. This machine also has a 5 year life. Sales are expected to grow @ 13.5 % pa after the first year sales of $ 1,000,000. Other costs are generally similar to option 1 with some variation in their magnitude. Findings and Discussion The analysis is for the two options of Option 1 Renew existing machine Option 2 Buy new machine and scrap existing machine Incremental cash flows for both the options Based on the parameters given, the year wise cash flows are as given in the table below. Few points to consider are For option 1, the renewal cost of $ 135,000 and factoring a scrap value of $ 8,000 can be financed with debt @ 6 % which has an annual payout of $ 30,629 For option 2, the renewal cost of $ 225,000 and factoring a scrap value of $ 25,000 can be financed with debt @ 6 % which has an annual payout of $ 48,979 Cash flow for Option 1 Profit Loss - Renew existing machine Year 1 2 3 4 5 Sales 800,000 908,000 1,030,580 1,169,708 1,327,619 Deprn ( 27,000 ) ( 27,000 ) ( 27,000 ) ( 27,000 ) ( 27,000 ) Advertising Marketing ( 30,000 ) ( 30,000 ) ( 30,000 ) ( 30,000 ) ( 30,000 ) Maintenance Costs ( 42,200 ) ( 42,200 ) ( 42,200 ) ( 42,200 ) ( 42,200 ) Operating costs ( 75,000 ) ( 75,000 ) ( 75,000 ) ( 75,000 ) ( 75,000 ) Profit before tax 625,800 733,800 856,380 995,508 1,153,419 Tax ( 187,740 ) ( 220,140 ) ( 256,914 ) ( 298,652 ) ( 346,026 ) Profit after tax 438,060 513,660 599,466 696,856 807,393 Cash flow 465,060 540,660 626,466 723,856 834,393 Alternative 1 Cash Flows Year 0 1 2 3 4 5 Total EMI for Renewal cost of existing machine ( 30,629 ) ( 30,629 ) ( 30,629 ) ( 30,629 ) ( 30,629 ) ( 153,147 ) Consultant cost ( 25,000 ) ( 25,000 ) Cash flow from machine 465,060 540,660 626,466 723,856 834,393 3,190,435 Advertising Marketing ( 30,000 ) ( 30,000 ) ( 30,000 ) ( 30,000 ) ( 30,000 ) ( 150,000 ) Maintenance Costs ( 42,200 ) ( 42,200 ) ( 42,200 ) ( 42,200 ) ( 42,200 ) ( 211,000 ) Raw material incremental capital ( 256,000 ) ( 34,560 ) ( 39,226 ) ( 44,521 ) ( 50,531 ) Operating costs ( 75,000 ) ( 75,000 ) ( 75,000 ) ( 75,000 ) ( 75,000 ) ( 375,000 ) Other expenses ( 352,000 ) ( 352,000 ) ( 352,000 ) ( 352,000 ) ( 352,000 ) ( 1,760,000 ) Increase in net WC ( 15,000 ) ( 15,000 ) Opportunity cost of selling existing machine ( net of tax ) ( 14,000 ) Tax on capital gain on sale of machinery ( 2,400 ) ( 2,400 ) Net Cash flow ( 126,200 ) ( 320,769 ) ( 23,729 ) 57,411 149,505 323,833 60,050 Cost of capital 17 % Net Present Value ( 154,363 ) Internal Rate of Return 3 % PI 0.4 Cash flow for Option 2 Profit Loss Year 1 2 3 4 5 Sales 1,000,000 1,135,000 1,288,225 1,462,135 1,659,524 Deprn ( 27,000 ) ( 27,000 ) ( 27,000 ) ( 27,000 ) ( 27,000 ) Advertising Marketing ( 30,000 ) ( 30,000 ) ( 30,000 ) ( 30,000 ) ( 30,000 ) Maintenance Costs ( 38,750 ) ( 38,750 ) ( 38,750 ) ( 38,750 ) ( 38,750 ) Operating costs ( 58,500 ) ( 58,500 ) ( 58,500 ) ( 58,500 ) ( 58,500 ) Profit before tax 845,750 980,750 1,133,975 1,307,885 1,505,274 Tax ( 253,725 ) ( 294,225 ) ( 340,193 ) ( 392,366 ) ( 451,582 ) Profit after tax 592,025 686,525 793,783 915,520 1,053,692 Cash flow 619,025 713,525 820,783 942,520 1,080,692 Alternative 2 Cash Flows Year 0 1 2 3 4 5 Total Purchase of new machine ( 48,979 ) ( 48,979 ) ( 48,979 ) ( 48,979 ) ( 48,979 ) ( 244,896 ) Consultant cost ( 25,000 ) ( 25,000 ) Installation cost ( 20,000 ) ( 20,000 ) Cash flow from machine 619,025 713,525 820,783 942,520 1,080,692 4,176,544 Advertising Marketing ( 30,000 ) ( 30,000 ) ( 30,000 ) ( 30,000 ) ( 30,000 ) ( 150,000 ) Maintenance Costs ( 38,750 ) ( 38,750 ) ( 38,750 ) ( 38,750 ) ( 38,750 ) ( 193,750 ) Raw material incremental capital ( 320,000 ) ( 43,200 ) ( 49,032 ) ( 55,651 ) ( 63,164 ) Operating costs ( 58,500 ) ( 58,500 ) ( 58,500 ) ( 58,500 ) ( 58,500 ) ( 292,500 ) Other expenses ( 345,000 ) ( 345,000 ) ( 345,000 ) ( 345,000 ) ( 345,000 ) ( 1,725,000 ) Increase in net WC ( 22,000 ) ( 22,000 ) Sale of existing machine 14,000 14,000 Tax on capital gain ( 7,500 ) ( 7,500 ) Net Cash flow ( 346,750 ) ( 222,204 ) 149,096 250,521 365,639 557,548 753,850 Cost of capital 17 % Net Present Value 471,973 Internal Rate of Return 27 % PI 3.4 Based on this analysis the Net Present Value for Option 1 @ cost of capital 17 % is negative $ ( 154,363 ). The Internal Rate of Return @ 3 % is less than the cost of capital. Even the profitability index is less than 1. For option 2, all the parameters of Net Present Value, Internal Rate of Return and PI at $ 471,973, 27 % , 3.4 respectively are favorable. Hence the recommendation is to go ahead with buying new machinery Net Present Value and Internal Rate of Return profile The Net Present Value and Internal Rate of Return profile table and graph are shown below Alt 1 Alt 2 Net Present Value ( 154,363 ) 471,973 Internal Rate of Return 3 % 27 % Though the Net Present Value is negative for Option 1, the Internal Rate of Return is still positive but substantially lower than the cost of capital. In option 2, Internal Rate of Return being higher than cost of capital, Net Present Value is positive. There is no conflict between Net Present Value and Internal Rate of Return for the two options Inflation linked Incremental cash flows for both the options Inflation linked Cash flow for Option 1 Profit Loss Year 1 2 3 4 5 Sales 800,000 908,000 1,030,580 1,169,708 1,327,619 Deprn ( 27,000 ) ( 27,000 ) ( 27,000 ) ( 27,000 ) ( 27,000 ) Advertising Marketing ( 30,000 ) ( 31,200 ) ( 32,448 ) ( 33,746 ) ( 35,096 ) Maintenance Costs ( 42,200 ) ( 43,466 ) ( 44,770 ) ( 46,113 ) ( 47,496 ) Operating costs ( 77,250 ) ( 79,568 ) ( 81,955 ) ( 84,413 ) ( 86,946 ) Profit before tax 623,550 726,767 844,407 978,436 1,131,081 Tax ( 187,065 ) ( 218,030 ) ( 253,322 ) ( 293,531 ) ( 339,324 ) Profit after tax 436,485 508,737 591,085 684,905 791,757 Cash flow 463,485 535,737 618,085 711,905 818,757 Alternative 1 Cash Flows Year 0 1 2 3 4 5 Total EMI for Renewal cost of existing machine ( 30,629 ) ( 30,629 ) ( 30,629 ) ( 30,629 ) ( 30,629 ) ( 153,147 ) Consultant cost ( 25,000 ) ( 25,000 ) Cash flow from machine 463,485 535,737 618,085 711,905 818,757 3,147,969 Advertising Marketing ( 30,000 ) ( 31,200 ) ( 32,448 ) ( 33,746 ) ( 35,096 ) ( 162,490 ) Maintenance Costs ( 42,200 ) ( 43,466 ) ( 44,770 ) ( 46,113 ) ( 47,496 ) ( 224,046 ) Raw material incremental capital ( 256,000 ) ( 34,560 ) ( 39,226 ) ( 44,521 ) ( 50,531 ) Operating costs ( 77,250 ) ( 79,568 ) ( 81,955 ) ( 84,413 ) ( 86,946 ) ( 410,131 ) Other expenses ( 364,320 ) ( 377,071 ) ( 390,269 ) ( 403,928 ) ( 418,066 ) ( 1,953,654 ) Increase in net WC ( 15,000 ) ( 15,000 ) Opportunity cost of selling existing machine ( net of tax ) ( 14,000 ) Tax on capital gain on sale of machinery ( 2,400 ) ( 2,400 ) Net Cash flow ( 126,200 ) ( 339,380 ) ( 63,309 ) ( 3,852 ) 65,821 230,185 ( 236,735 ) Cost of capital 17 % Net Present Value ( 324,807 ) Internal Rate of Return -14 % PI ( 1.8 ) Inflation linked Cash flow for Option 2 Profit Loss Year 1 2 3 4 5 Sales 1,000,000 1,135,000 1,288,225 1,462,135 1,659,524 Deprn ( 27,000 ) ( 27,000 ) ( 27,000 ) ( 27,000 ) ( 27,000 ) Advertising Marketing ( 30,000 ) ( 31,200 ) ( 32,448 ) ( 33,746 ) ( 35,096 ) Maintenance Costs ( 38,750 ) ( 39,913 ) ( 41,110 ) ( 42,343 ) ( 43,613 ) Operating costs ( 58,500 ) ( 58,500 ) ( 58,500 ) ( 58,500 ) ( 58,500 ) Profit before tax 845,750 978,388 1,129,167 1,300,546 1,495,314 Tax ( 253,725 ) ( 293,516 ) ( 338,750 ) ( 390,164 ) ( 448,594 ) Profit after tax 592,025 684,871 790,417 910,382 1,046,720 Cash flow 619,025 711,871 817,417 937,382 1,073,720 Alternative 2 Cash Flows Year 0 1 2 3 4 5 Total Purchase of new machine ( 48,979 ) ( 48,979 ) ( 48,979 ) ( 48,979 ) ( 48,979 ) ( 244,896 ) Consultant cost ( 25,000 ) ( 25,000 ) Installation cost ( 20,000 ) ( 20,000 ) Cash flow from machine 619,025 711,871 817,417 937,382 1,073,720 4,159,416 Advertising Marketing ( 30,000 ) ( 31,200 ) ( 32,448 ) ( 33,746 ) ( 35,096 ) ( 162,490 ) Maintenance Costs ( 38,750 ) ( 39,913 ) ( 41,110 ) ( 42,343 ) ( 43,613 ) ( 205,729 ) Raw material incremental capital ( 320,000 ) ( 43,200 ) ( 49,032 ) ( 55,651 ) ( 63,164 ) Operating costs ( 58,500 ) ( 58,500 ) ( 58,500 ) ( 58,500 ) ( 58,500 ) ( 292,500 ) Other expenses ( 345,000 ) ( 345,000 ) ( 345,000 ) ( 345,000 ) ( 345,000 ) ( 1,725,000 ) Increase in net WC ( 22,000 ) ( 22,000 ) Sale of existing machine 14,000 14,000 Tax on capital gain ( 7,500 ) ( 7,500 ) Net Cash flow ( 346,750 ) ( 224,567 ) 142,634 239,817 350,543 550,577 712,253 Cost of capital 17 % Net Present Value 431,098 Internal Rate of Return 26 % PI 3.2 Base Case with Sensitivity Since only Option 2 is feasible, the sensitivity is done on Option 2. Currently, the operations and maintenance cost for Option 2 aggregate $ 97,250 and the project has a positive Net Present Value. In case the expenses rise to $ 148,019 (i.e. an increase of $ 50,769, the project becomes un feasible) Currently, the sales for the first year are $ 1000,000. In case, the sales drop to $ 882,080, the option becomes unfeasible since the Net Present Value is below zero. Option of Operating versus Finance Lease Since the borrowing rate is lesser than the cost of capital, it makes sense for the company to lease the new craft machinery. Among lease, the choices are operation lease or finance lease. In operating lease, the ownership of the asset will be with the finance company. Hence depreciation and tax benefits on the same cannot be claimed by Lifestyle. In finance lease, since the ownership of the asset will be with the Lifestyle, they can claim depreciation and tax benefits on the same. The finance company will accordingly adjust the lease rentals to reflect this fact Calculation of Weighted Average Cost of Capital The company has the following parameters and based on that the Weighted Average Cost of Capital is as under Cost Book Market Cost of equity 17 % 1,060,000 3,000,000 AT cost of debt 6 % 4,000,000 3,840,000 Preference Shares 13 % 40,000 60,000 Total 5,100,000 6,900,000 Weighted Equity 21 % 43 % Weighted Debt 78 % 56 % Weighted PS 1 % 1 % Weighted Average Cost of Capital 8.3 % 10.8 % On book value basis, the weighted debt is 78 % of the capital mix compared to 56 % in the case of market method. This is compensated by the equity and preference share weights. Since the cost of debt is lowest @ 6 % and the book method gives highest weightage to debt, the Weighted Average Cost of Capital for book method is lower than market method. Recommendation Lifestyle has to cater to the growth prospects it envisages in future. Based on the analysis above, the recommendation is to buy the new age craft machinery i.e. Option 2 for the following reasons The Net Present Value, Internal Rate of Return and PI for Option 2 is higher than Option 1 . Net Present Value for Option 1 is negative and hence the option is outright discarded Even after adjusting for inflation, the conclusion does not change. References "Profitability Index - Complete Guide To Corporate Finance | Investopedia".Investopedia. N.p., 2012. Web. 30 May 2016. S, Surbhi. "Difference Between NPV And IRR (With Comparison Chart) - Key Differences".Key Differences. N.p., 2015. Web. 30 May 2016.