The Chocolatey Project
Hot n Sweet Company is considering the introduction of new product (Chocolatey) in the market to augment an already existing product (Choco). The company has an expenditure budget of $2 Million and a limited factory space of 2500 sq ft. this space is more than enough to go ahead with the project.
The company wanted to lease this part of company space at $150000 per year if the project had not come about. However, the new product is supposed to contribute towards paying rent for the factory space, which is estimated at $140000 per year.
The company has also use $190000 to renovate the space where the product will be produced. The equipment for the project would cost £1.9 million, including shipping and installation.
The equipment would have no residual value at the end of the planned project period of 5 years, and would have to be completely replaced if the company wants to continue the project thereafter.
Average level of working capital investment required to be carried in any year would need to be roughly equal to 10% of the year’s estimated revenue. This project , it is expected, is going to take away sales from “Choco”, on which Hot n Sweet Company presently earn a contribution of £12 a unit.
About 35,000 units per annum because of introducing “Chocolatey” would reduce sales of “Choco”. The company estimates a demand of 110,000 units in the first year, increasing at an average growth rate of 7% per year for the duration of the project at a selling price fixed at $38 per unit.
The company estimates that the cash operating cost – that is, the operating cost before charging depreciation – would amount to about 42% of the selling price.
In addition, the company would apportion administrative costs of £250,000 per annum, extra sales promotion expenses of £250,000 a year, and interest charges of £120,000 on the loan needed to finance the project. All of the revenues and costs that we have estimated are at today’s prices.
The tax authorities allow the company to charge straight-line depreciation over the life of the project, i.e. 5 years. The administrative costs do not include the salary of the supervisor who would be shifting an existing supervisor from “Choco” to “Chocolatey”.
The supervisor was due to take his pension of £35,000 per year and retire but agreed to stay on for the duration of the project at his existing salary of £55,000 per annum. It is expected that the current tax rate of 30% would continue for the duration of the project.
The company’s after-tax weighted average cost of capital is 16%, and is not expected to change because of the project.
On the other hand, the company analyst prefer my alternative proposal for capital investment of £2 million for additional production of “Choco” for the Asian and Far Eastern market at the existing price of £50 a unit (Fayweather & Kapoor, 1976).
This will generate net after-tax cash flows of £1.6 million per year for the first two years (at today’s prices).
The net after-tax cash flows would fall off to $500000 per year (at today’s prices) for the next three years thereafter, but the project has a very high IRR and a quick payback period – both of these are arguably better than for the proposed “Chocolatey” project (Spulber, 2007).
Executive Summary
Preliminary NPV analysis shows that the company should confidently pursue the introduction of the new product (Chocolatey) to the market. This is because it is a low risk project with a high Internal Rate of Return (166%). The cash flows pertaining to Project Chocolatey are good.
Additionally, the payback period is satisfactory (1.59 years). The company does not provide critical information to enable the consultants to weigh the other project under consideration adequately.
However, Chocolatey project has a high NPV of 3,759,826.14, which further underscores the viability of the project. Project Chocolatey has a high Accounting Rate of Return of 22.67% and a Profitability Index of 1.88.
Explanation of the NPV Analysis Results
NPV Analysis results in a positive NPV of 3,759,826.14. This indicates that the management can undertake this project. An NPV that is greater than zero means that the project is viable. Additionally, during the period in which the project will be implemented, the company will register the following undiscounted cash flows.
Table 1: Cash Flows of Chocolatey Project
This indicates that the project is quite good with great returns on capital. It also indicates that Hot n Sweet Company will not have problems with cash flows even in the initial stages of the project.
In comparison to the other option, unveiling this new brand looks like a more promising option. Table 2 below shows comparison of the two projects’ cash flows (Chapman, Hopwood & Shields, 2006).
Table 2: Comparison of Project’s Cash Flows
As shown in Table 2 above, Project ‘Chocolatey’ has a better return in terms of cash flows compared to Project ‘Choco’. While the first project indicates cash flows that are relatively stable over time, the second indicates cash flows that decline too fast.
The graph below indicates that in each year of the project’s lifetime, ‘Chocolatey’ project records better cash flows (Frynas & Mellahi, 2011).
Figure 1: Comparison of Cash flows.
As figure one above indicates, there is relative stability in the cash flows recorded by Project Chocolatey as compared to Project Choco. This follows that it would be too hard to determine which Project to pursue using cash flows (Haberberg & Rieple, 2007).
The Marketing Manager does not provide the IRR for Project Choco. She only states that the project’s IRR is high (62%). Based on the cash flows of project Chocolatey, the calculated IRR is 170%.
This is also a high score. Hence, although the IRR for the second project is high, it is imperative to note that the first project (Chocolatey) will have better returns to shareholders. Hence, it shows that it will grow at a better rate (Chapman, Hopwood & Shields, 2006).
Free Cash Flow (FCF), ARR and Profitability Index
Table 3: Other Appraisals
Table 3 above indicates other appraisals.
A positive Free Cash Flow figure $470,836.66 indicates that the company will have enough cash to meet its capital expenditure requirements and provides opportunities for the company to enhance shareholder value. Profitability Index indicates the return on every dollar invested in the project.
For every $1 invested, the company enjoys a return of $0.92 (Lorat, 2009). This indicates that this project will be quite profitable and the company should pursue it.
The accounting rate of return indicates return on money invested without considering time value of money. It is simple and reduces complications associated with other appraisal tools. In this Project, the ARR is 23.48% (Johnson, Scholes & Whittington, 2011).
Based on Payback Period
Comparing the two projects based on the payback period, the better project has a shorter period within which the company can recoup its investment. Again, The Marketing Manager does not indicate the exact Payback period for the ‘Choco’ project.
From the calculations, Chocolatey project will recoup its investment in 1.57 years. This means that the rest of the time the company will be enjoying profits (Mintzberg & Ghoshal, 2003).
The company does not also indicate targeted Payback period for either project. However, the following comparison indicates Project Chocolatey is better as it results in a shorter period.
Operating Expenses
The operating expenses of Chocolatey project are too high. According to the calculations, the following indicates the operating expenses that the project will attract over its lifetime.
Table 4: Operating expenses
Although we do not have a basis for comparing with the other project, this cost carries the highest margin of cost compared to the rest of the costs. Table 3 indicates that the cost increases over time because of the gradual increase in revenue.
However, this is not economical as it shows that the company does not have economies of scale. Normally this cost would reduce as the number of unites produced increases owing to the reducing overheads (Kay, 1993).
The project’s equipment also depreciates at a very high rate. This dilutes the gains that the company makes. It follows that it would be better to expand the production of the ‘Choco’ Brand if the lifetime of the equipment to produce this new product is that expensive and without a residual value (Hitt & Hoslisson, 2008).
The company’s Weighted Average Cost of Capital is too high. However, when chair Michael brings this to the fore, Managing Director Julie Wang counters by arguing that the inflation rate is expected to remain constant during the life of the project and that inflation affects both the revenues and the costs.
Hence, the net effect reduces its impact. However, this does not discount the fact that it is still a high level of cost of capital. The team does not discuss the prevailing market rates to form a good basis for comparing so that a better figure may be arrived at (Johnson, Whittington & Scholes, 2011).
According to preliminary cash flow analysis, the project to build a new facility should be expeditiously undertaken. The project will require an initial investment of -1,900,000.00. The amount will be used to purchase the new equipment and for installation in the new facility.
The company will also incur additional costs in the form of lease payments and working capital investments. The new facility will enable the company gradually expand its production capacity and meet an estimated demand of 110000 units annually. It will also reduce the demand for the previous product by 35000 units.
The increased revenues will exceed the variable costs and will enable the company cover their fixed costs (Barney, 2002). The incremental cash flows will result in a positive net present value of the new Chocolatey project. The company will also benefit from the incremental depreciation tax shield.
The company can deduct the amount spent on the new equipment gradually over 5 years from the reported income. The increased production will allow the firm to increase its market share as noted from the sales figures above. The company also benefits from the reduced variable production costs.
The variable costs reduction can be attributed to expected economies of scale and the improved processes likely to be incorporated in the new facility. The lease payments on the new facility represent a huge increase in cash outflows brought about by a possible decision to unveil the new product (Ahrens & Chapman, 2007).
As seen from the sensitivity analysis, the project has a low risk.The company will still enjoy increased shareholder wealth from the positive net present value of the cash flows over a wide range of possible costs of capital (Henry, 2008).
The expansion will thus insulate the company from the effects of the fluctuating cost of capital. All in all the company will be in a better financial position in the future after expanding production to the new facility.
The company should therefore overlook the huge capital outlay and focus on the future benefits the expansion will bring about (Drury, 2007).
Sensitivity Analysis
This method analyses the risk surrounding a capital expenditure project and it enables a firm to determine which variable, NPV is most sensitive to. Project variables include, initial cost, cash flows, useful life, cost of capital etc (Urquiola & Hudson, 2007).
In the case of Hot n Sweet Company, unveiling Chocolatey should be undertaken regardless of the fluctuations in the discount rate. This is because the NPV remains positive throughout the range and the IRR (170%) remains higher than the cost of capital (16%).
Despite the possible adverse changes in discount rates (13.5%-18.5%), the project will still be viable and will lead to an increase in shareholder wealth. The table below (Table 4) shows this (Ahrens & Chapman, 2007).
Table 5: Sensitivity Analysis
A Critical Look
The management team had a great understanding of the needs of the project. They had a detailed outlook regarding the parameters of the project too. However, most of them lacked initiative. The CEO asked the questions.
For example, while discussing the equipment for the new project, Manager for Research & Development did not go to the last detail about the salvage value.
He only indicated the amount, which the company will use to purchase it and the lifetime of the equipment but did not indicate the salvage value until he was asked by the chair (Castells, 2011).
In another instance, he did not indicate to the meeting that the company wanted to lease the area on which the new project would be done for $150,000 until the chair queried him (De Wit & Meyer, 2004).
It is imperative to note that, The Marketing Manager provided the details for other project option. However, she provided considerably scanty details regarding it. Hers were just generalist conclusions.
For example, she only noted that the other project had a high Internal Rate of Return with providing the calculated figure (Duncan, 1972). This did not help in the preparation of this report, as it did not give a good basis for comparison of the two projects.
Additionally, she did not provide the Payback Period despite stating that it would be shorter than the ‘Chocolatey’ project’s despite having known what the exact payback period for it would have been. This shows a knack for overlooking details and honing assumptions (Hansen, Mowen & Guan, 2007).
There was notable absence of participation from some members. The Personnel Manager spoke only once when she was explaining the issue with the transfer of a supervisor form ‘Choco’ to ‘Chocolatey’. However, this shows that managers have a clear understanding of their portfolio (Davila & Foster, 2005).
Conclusion
It would be in the interest of the company to undertake the Chocolatey Project. This is because it arrives at a positive NPV and a high internal rate of return. The sensitivity analysis also indicates that this project is highly flexible to any change to cost of capital.
This is despite the fact that the meeting had noted that this is unlikely to happen. Hence, this project has the capacity to increase the wealth of shareholders. It also has the capacity to expand the market share of the company if the demand levels are anything to go by (Schreyögg & Busse, 2006).
The other option in which the company considers expanding an existing product (Choco) to new markets in Far East and Asia does not have enough information to allow for enough appraisals.
However, the figures presented by The Marketing Manager are an indication that the Chocolatey project is better. This is despite the fact that there may be training required for technical staff which the meeting does not mention (Koontz & Weihrich, 2007).
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