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Lincoln Sports Equipment: Capital Budgeting Case Study

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Updated: Jul 6th, 2021

Executive Summary

The Lincoln Sports Management Team has to decide on the best alternative between the continuation of the limited production and full production of the new cleats. The financial analysis suggests that the second alternative would make economic sense and should be adopted. This means that full production should be favored to limited production. The calculations indicate that limited production has a positive NPV only in the optimistic market scenario, while full production has a positive NPV in all scenarios. Moreover, the cost for goods sold under the full production is based at 64% of all sales or a profit of $10.08 per cleat. On the other hand, the cost is 67% with a profit margin of $9.24 per cleat. The ENPV value also suggests that a full production option would be ideal for the team. Specifically, the NPV for full production is $542,703 and -$173,435 for limited production.

When the tests are subjected to different scenarios following adjustments in each scenario, the full production alternative would still give the best results as compared to the limited production option. For instance, under the base case scenario, the sales remained at $28 per unit for both cases. The same scene is depicted in the pessimist scenario, where the sales increased by 2% per unit. In the optimistic scenario, there was a 6% price per unit increase for both cases. Lastly, the guess best scenario presented a sale price increase by 4%. The unit sales also went up by 110% on new cleats and 120% on old cleats. In this scenario, the cost of production for the full option is 64% while that of limited production is 66%. At the same time, the cost of old cleats is 70%. Based on the results of the analysis, Lincoln Sports should consider the optimistic scenario because it brings positive profits, irrespective of the market testing and market conditions in the production of new cleats.

Introduction

The Lincoln Sports Management Team is faced with a decision-making challenge on the sustainability of the New Cleat project. Specifically, the team is interested in establishing the best alternative to take between full and limited production of the new cleats from a financial perspective. Specifically, the team wants to know the probability of success or failure of the two alternatives to adopt the soundest business project. The decision-making process will be angled on the sunk cost of production in each alternative, profit margin, and differences in the number of units sold for each assumption scenario. This analytical paper presents an evaluation of these two alternatives using different financial tools to establish the best option for the company. The analytical tools to be used include operating cash flow, networking capital, free cash flow, and expected net present value. The analysis will be based on the assumptions that market testing cost is a one-time fixed expense, probability of failure or success and the NPV are positive values. In addition, the cost of capital is assumed to be 15% to generate a positive NPV. The estimated tax rate is 40% while the terminal value is assumed at 30% of the initial investment. The analysis will also be done by considering different scenarios when the assumptions are changed, such as base case, pessimistic, optimistic, and best guess. The best alternative will be presented following comprehensive sensitivity analysis.

Methodology

Operating cash flow (OCF) is the amount of cash that a company generates from normal operations. It is a good indicator to see whether the company generates enough to meet its financial needs or if it requires external financing to cover for the change in its projected sales growth, or in the case of Lincoln Sports, the increase in its projected sales price. OCF calculations start with subtracting the cost of goods sold from revenues. We then go on and begin to subtract expenses associated with the production of cleats, including administrative, marketing, and miscellaneous expenses to get earnings before interest and taxes, or EBIT. Since we are not dealing with any interest, we can subtract the tax expense from EBIT to calculate the operating income. We add back depreciation at the end of net income calculations because depreciation is a non-cash expense, which yields OCF. We have an inaccurate cash flow balance at the end if we do not add back non-cash expenses. To calculate the pro forma OCF, we simply calculate the income statement using the projected change in sales price. By doing this we generate a different operating net income, which we add depreciation to calculate the new OCF.

Net working capital is calculated by taking the difference between current assets and current liabilities and measures how well a company can cover its short-term debts with its short-term assets. In the Lincoln Sports case, we are only given the steps to calculate inventory and accruals. We need to calculate Account Receivables, Average Collection Period, or ACP, and Account Payable. To calculate Accounts Receivables, we need to first find the ACP. ACP can be found by taking the percentage of people that opted for the net 30 and the net 45, including those that paid on time and those that paid 10 days late from net 30, adding those numbers up, and finding ACP.

We know that 70% of customers opted for net 30, of which 80% paid within those 30 days and 20% paid 10 days late, and 30% opted for net 45, where all the customers paid on time. We can multiply the 80% of net 30, add the 20% who paid 10 days late, multiply the sum by the 70% who opted for net 30, and add the product of the 30% of customers who opted for net 45. From here, we can use ACP to find the Account Receivables Turnover by multiplying the ACP by 360 days. Then we can then use the AR Turnover to calculate Accounts Receivables for Lincoln Sports. The same steps can be used to determine the Accounts Payable except this time we are given the Average Payment Period or APP and we use Purchases, which is 80% of Cost of Goods Sold, as opposed to Sales. Once we have these numbers, we can calculate total current assets and total current liabilities to find the networking capital. For the final year, we add back all the networking capital back.

Free Cash Flow, or FCF, is like OCF in that it tells how much cash is generated by the company. The difference is that FCF subtracts capital expenditure which makes it a better method in calculating a company’s financial performance. In this case, FCF is calculated by taking the OCF of the new cleats, subtracting the OCF of the old cleats, and either adding or subtracting the change in net working capital. You can determine whether to add or subtract the change in networking capital by looking at whether it’s positive or negative. You add a negative change in net working capital and subtract a positive change in net working capital. For the final year, you would add the change in networking capital to determine FCF for that year. People have the misconception that a negative FCF is a bad thing. A negative FCF could show that the company is making some major investments that will pay off in the future.

Since Lincoln Sports is trying to determine whether to add these new cleats in Full Production or Limited Production, we need to calculate the Expected Net Present Value or ENPV. ENPV takes into consideration both the NPV of the Full Production line and the Limited Production line. Something to remember when considering NPV is that it is only relevant if it is greater than zero. A negative NPV simply means that the company shouldn’t even bother with that production line. With this, we needed to make sure that the ENPV equation only considers positive NPV and excludes negative NPV. For this to work, we include an “IF” function in our equation to exclude NPV if it is negative. Market testing is the value that the company has paid to determine the probability of success within each production line. We can take the NPV from each production and multiply them by their respective probability of success, add both together, discount them back one period since it is calculated on the first year, and add that value to the market testing to determine the ENPV.

The decision tree above shows the split between Full Production and Limited Production along with their respective probabilities of success. Based on the information given from the case, we can see that the initial investment occurs in the year t + 1, or 1997. The reason for this is that the first year, 1996, is used for market testing. The company starts generating OCF from 1998 up to 2003 where we will generate OCF for new cleats in Full Production, subtract OCF of old cleats, either add or subtract the change in net working capital and use that information to generate FCF for each year. For 2003, we need to add the after-tax salvage value because it is what the company will receive when it sells off the asset at the end of its useful life. This method is used for Full Production and Limited Production alike. With the decision tree filled out completely, the company can generate the NPV of each production line as well as the ENPV. This information is useful to determine whether the company should go through the production of new cleats, or if they should investigate other alternatives such as the ball department explained in the case.

Assumptions

The assumptions made for this case are reflective of the decisions made by the Lincoln Sports Management Team. The research and variables given by the management will be assumed correctly to be able to complete the analysis for this case.

General Assumptions

The general assumptions capture the variables of market testing (fixed), probability of success and failure (at positive ENPV), and full and limited production (positive ENPV). The cost of capital is set at 15%, while the tax rate is at 40%. The terminal value is set at 30% of the initial investments. Lastly, the networking capital is also fixed as discussed in the next section.

Market Testing

Market testing is a way to determine whether a project will meet the market requirements and estimates if a project will be profitable for a firm or not. In this case, the first-year marketing test cost $125,000, this will be a one-time expense incurred at the beginning of the project’s life in 1996. It is necessary to determine the effectiveness of the project and its worth to the firm.

Probability of Success and Failure

The market testing research has given the Lincoln Sports Management Team that the new cleat has a 75% chance of meeting the company’s profitability requirements and a 25% of not meeting the company’s expectations. The effective NPV of the new project is $228,936 meaning that given the probabilities of success and failure as well as the other assumptions the project would result in a positive value generated to the firm. Fluctuations in the market and competitor’s cleats could change these projections and therefore, change the effective NPV of the new cleat. In this case, the probability of success or failure was set at a positive value of the ENPV to guarantee positive profit to cushion the project from any extreme market dynamics.

Full & Limited Production

There are two production options for the Lincoln Sport’s new cleat; full production with an NPV of $542,703 or a limited production option with an NPV of -$173,435. The effective NPV with the probabilities of success and failure factored in is $228,936, which is the only NPV to consider until the new cleat hits the market.

Cost of Capital

The cost of capital is the required return for the new cleat project. The cost of capital is 15% so the project must generate a 15% return to have a positive NPV. It states in the case this is a conservative estimate and could be lowered to accept the project at a lower NPV if the management team deems the project a worthy risk.

Tax Rate

The tax rate for the Lincoln Sports Company is 40%, this is a federal rate and must be considered in the projected operating cash flows for the new cleat. This is non-negotiable and may not be changed to turn a profit.

Terminal Value

The terminal value or after-tax salvage value is the amount of after-tax value that the management team is estimating the project’s assets will be able to be sold for after the project is ended. The Lincoln Sports management team has estimated the after-tax terminal value to 30% of the initial investment. The only thing they are estimating to have residual value after the life of the project is the fixed assets. This cash flow will be factored into the NPV in the final year of the project as the fixed assets are sold off or repurposed for another project

Net Working Capital Assumptions

The accounts receivable period is fixed at 35 days. The inventory is also fixed over the same period while the accounts payable days are adjustable. The last assumption is that other current liabilities such as the increasing amount, fixed amount, growth percentage, and the percentage of sales are flexible at each discount rate. These assumptions are discussed in the next section.

Old Net Working Capital

The old networking capital is fixed and not affected by other costs or interactions with assumption variables. This means that the old networking capital is predetermined and set at a fixed rate of 12%.

Average Collection Period (ACP) and Average Payment Period (APP)

The average collection period estimated for the project is 35.9 days, to get this they took the weighted average of the expected collection period for the expected customer base. This means that the company is expecting the average to be 35.9 days between when a credit sale is made, and the customer pays for the purchase. Generally, the lower the ACP the better, as the company would receive the cash from its accounts receivable sooner. Cash is more valuable to the company than accounts receivable as it is received income, as well as it more liquid and can be used in other areas of the company. The average payment period is 30 days, which means that the Lincoln Sports company will pay its debts or accounts payable due within 30 days on average.

Inventory

The inventory is estimated to be about 15% of sales, this represents the amount of inventory that Lincoln Sports will have through the production years of the new cleat. As it is estimated as a percentage of sales, inventory would increase as sales increase. There will be a higher inventory with the full production than the limited and there will be increasing inventory while the production of the new cleat increases in the beginning years. In the project, the current assets are only accounts receivable and inventory. A higher current asset could affect the ratio analysis of the project and the company as well as the networking capital needs of the project.

Accruals

The accruals are estimated at 2.2% of sales and are representative of the accruals made for the new cleat project during its years of production. The accrual rate is steady at 2.2% for all years of production. Accruals are also important as combined with accounts payable, make up the entirety of the total current liabilities of the project, which influences the net working capital needed for the project. Like inventory, this increases and decreases with sales which will affect the liabilities which has effects on the net working capital required and financial ratios.

Purchases

The purchases would be the raw materials and things like that needed in production, for this project it is estimated at 80% of the cost of goods sold. If the cost of goods sold remains a reasonable percentage of sales, purchases will still be in check and the company will be able to turn a profit. The remaining 20% of the cost of goods sold is the standard operating cost of production.

Scenario Analysis Assumptions

To test the assumptions made by the Lincoln Sports management team about the new cleat, they have created multiple scenarios to test the strength of their assumptions. The various scenarios are a pessimistic scenario testing the worst case, a best-guess scenario testing a most likely and middle ground, and an optimistic scenario testing if everything went in the company’s favor.

Pessimistic

For the pessimistic or worst-case scenario, the company estimates that the unit sales of the new cleat be 90% of the standard projections. They are also estimating the old cleat to sell at 130% of the projections. Also, they have decreased the chance of success to 60%. The cost of goods sold would be 66% at full production, 68% at limited production, and 70% for the old cleat. The price they would sell the cleat at would start at $28 and increase by 2% per year. The new discount rate for this scenario would be 20%.

Assumption Value Compared to Base Case Projection
Unit Sales (Full + Limited) 90%
Unit Sales (Old Cleat) 130%
Success Probability 60%
COGS (Full Production, Limited, Old Cleat) 66%, 68%, 70%
Selling Price (New Cleat) $28 + 2% per year
Discount Rate 20%

Best-Guess

For the best-guess scenario, the Lincoln Management team estimates the unit sales to be 110% for full and limited production and the unit sales for the old cleat will be estimated at 120%. The probability of success will be estimated at 75%. The cost of goods sold for full production, limited production, and the old cleat is 64%, 66%, and 70% respectively. The estimated selling price for the new cleat will start at $28 per cleat and increase by 4% per year. The estimated discount rate for this scenario is 15%.

Assumption Value Compared to Base Case Projection
Unit Sales (Full + Limited) 110%
Unit Sales (Old Cleat) 120%
Success Probability 75%
COGS (Full Production, Limited, Old Cleat) 64%, 66%, 70%
Selling Price (New Cleat) $28 + 4% per year
Discount Rate 15%

Optimistic

For the optimistic scenario, the estimated unit sales for full and limited production will be 120% of the original projections, as well as the old cleat being estimated at 110% of the standard projections. The probability of success for this scenario is being estimated at 80%. The cost of goods sold for the full production, limited production, and the old cleat is being estimated at 64%, 66%, and 70% respectively. The discount rate for this scenario is estimated at 15%.

Assumption Value Compared to Base Case Projection
Unit Sales (Full + Limited) 120%
Unit Sales (Old Cleat) 110%
Success Probability 80%
COGS (Full Production, Limited, Old Cleat) 64%, 66%, 70%
Selling Price (New Cleat) $28 + 6% per year
Discount Rate 15%

Ball Department

The Lincoln Sports Management team would also like to see the project value if they were to add a ball department. This would cause an additional $90,000 in initial cost for the new cleat as some of the equipment would be instead used for the ball production. There would also be an additional equipment initial investment of $15,000 for the ball department. This would generate $28,000 of net income or free cash flows per year for the next 8 years. It would generate an NPV or $101,492, an ENPV of $88,254, and a project ENPV of $280,916.

Assumption Value for Ball Department
Additional Fixed Cost for New Cleat (Ball Dep.) $90,000
Additional Equipment $15,000
Free Cash Flow or NI generated (Ball Dep.) $28,000
NPV $101,492
ENPV $88,254
Project ENPV $280,916

Scenario Summary

Different scenarios present different results. For instance, under the base-case scenario, the NPV for full production was estimated at $542,702 while the same figure for NPV in limited production was -$173,435. The ENPV variance was $228,936. Under the pessimistic scenario, the NPV for full production and limited production were $64,010 and $302,928, respectively. In this scenario, there was a negative ENPV. In the optimistic scenario, the NPV for full and limited production was $1,284,701 and $24,424 while the ENPV was at $772,953. Lastly, the best guess scenario had an NPV for full and limited production at $992,282 and -$83,583 with an ENPV of $476,488. The optimistic scenario attracted the highest NPV for full production. If all other factors are held constant, the optimistic scenario would give the team the highest positive profit margin for full production of the cleats.

Results

Expected Net Present Value, or ENPV, is useful in determining the overall present value of the entire project and seeing which departments are worth keeping or discontinuing. By looking at the ENPV of the Full Production and Limited Production of new cleats, the company favors going through with the Full Production of new cleats, which of course depends solely on the success of the market testing. In any scenario, Limited Production yields a negative NPV which is not a valuable option for the company to pursue. The only exception to this is the Optimistic scenario where the probability of success of the market testing is 80% and the discount rate hits 20%. Lincoln Sports should only introduce the new cleats if the market testing is successful since they will end up losing money otherwise. The NPV of the Full Production of cleats is $542,703 while the NPV of Limited Production is -$173,435 which results in an ENPV of $228,936 showing the importance of the success of the market testing. When calculating ENPV, we only consider NPV that is positive since a negative NPV should never be in consideration when dealing with the overall value gain of the project.

Lincoln Sports also considers the possibilities of different scenarios occurring by changing some of their assumptions. They consider four different scenarios: base case, pessimistic, optimistic, and best guess. Each scenario has different assumptions that are used to determine the performance of the cleats in the market and what value could potentially be added to the company if any.

The base case is the scenario where the results are dependent on the assumptions they originally come up with. In this case, sales remain at $28 per unit, unit sales do not have a growth rate per year, cost of goods sold for Full Production is 64%, Limited Production is 67%, and old cleats are at 70% of sales, the discount rate is 15% and the probability of market testing success is 75%. This results in an NPV of $542,703 for Full Production, -$173,435 for Limited Production, and an ENPV of $228,936.

If the pessimistic scenario were to occur, sales per unit increase by 2% which sounds like a good call. However, unit sales drop to 90% of the original estimate for both Full Production and Limited Production while the unit sales of old cleats increase by 130% the original value. The cost of goods sold for Full Production is 66%, 68% for Limited Production, and 70% of sales for the old cleats. The probability of market testing success falls to 60% and the discount rate rises to 20%. With the pessimistic scenario, NPV for FP drops to $64,010, LP has a further decrease down to -$302,928 and results in an ENPV of -$92,995. The decrease in NPV is due to the increase in costs as well as the decrease in unit sales for Full Production and Limited Production while an increase in unit sales for old cleats, which results in a lower change in net working capital, a lower OCF for Full Production and Limited Production, an increase in OCF for old cleats, and in turn, a lower FCF.

In the optimistic scenario, the price per unit has an increase of 6%, unit sales for Full Production and Limited Production go up by 120% of the original amount, old cleats have an increase of 110% of the original amount. The cost of goods sold for Full Production is 64%, 66% for Limited Production, and 70% for old cleats. The discount rate in this scenario is 15% and the probability of market testing success jumps up to 80%. A higher sales increase in new cleats from old cleats will result in a higher change in NWC, OCF, a higher FCF, and in turn, increases NPV for both production lines as well as ENPV. Full Production NPV is $1,284,701, Limited Production is $24,424, the only scenario where Limited Production of new cleats generates profit for the company, and an ENPV of $772,953.

Lastly, with the best guess scenario, sales price goes up by 4% each year, unit sales go up by 110% on the new cleats and 120% on the old cleats, cost of goods sold on Full Production are 64%, 66% on Limited Production, and 70% on the old cleats. The discount rate is 15% and the probability of market success is at 75%. OCF in this scenario goes up for both the new cleats and the old cleats, the change in NWC goes up, though at a slower rate than the OCF and in turn, causes FCF to rise. NPV for Full Production is $982,282, Limited Production is -$83,583, and ENPV is $476,488.

With the different scenarios listed, Lincoln Sports would appreciate the optimistic scenario to occur since it brings positive profit to the company regardless of the success of the market testing and the production that the new cleats go through. Every other scenario being run would cause a loss in profit if the market testing ends up not being successful, in other words, the Limited Production. Ideally, Lincoln Sports should adopt the optimistic scenario since the positive ENPV for both alternatives would ensure that there is profit and least possible losses that can be related to market dynamics. Although other scenarios have positive NPVs, except the pessimistic scenario, it would be ideal to weigh their overall benefits in terms of units sold and change in the profit margin. In the optimistic scenario, profits are positive for limited and full production alternatives with a variance of less than 1%.

Based on the original assumptions, a further sensitivity analysis revealed that ENPV would be $192,662 when the NPV for full production is at $487,082 and NPV for limited production is at -$229,058. The assumptions for the ball department give an ENPV of $88,254 when the NPV is $101,492. The ENPV for the project was further scrutinized for different discounted rates and probability of success. The findings revealed a positive value for the ENPV for discount rates that are below 20% for all probabilities of success. However, at a 20% discounted rate, there was a negative ENPV at 0.55 and 0.60 probability of success. The highest probability of success was recorded at a 12% discount rate and the value reduced uniformly up to 19%. This is a clear indication that the project would be viable at a 12% to 19% discount rate after which it would no longer make any economic sense. The highest ENPV recorded was at a 12% discount rate and a 1.00 probability of success at $471,706.

One of the discussions between employees of the Lincoln Sports company is the issue of whether to continue producing the old cleats or discontinue the product and invest that into the ball department, which has the potential of bringing in profit into the company. If the company is to invest in the ball department, there is an increase in fixed costs of $90,000, which was originally subtracted if they discontinued the ball department. That would put the initial investment up to $890,000 for the Full Production and $480,000 for the Limited Production.

The increase in initial investment results in a decrease in NPV of Full Production and Limited Production of the new cleats since the cash outflow, a negative value, is added to the NPV equation, which yields a lower ENPV of $192,662. There is an additional $15,000 in equipment cost that comes with the addition of the ball department. We use this $15,000 as the initial investment, as well as the Free Cash Flow for t+1, or 1997. We also include $28,000 in additional cash flow which is used to calculate the free cash flow generated by the ball department. When it comes to calculating the NPV of the ball department, we take all the free cash flow from t+1 up to t+8, use the discount rate, and generate the NPV for the ball department. As we can see, assuming a base case scenario, the ball department generates an NPV of $101,492, meaning that Lincoln Sports can consider the ball department as it generates a positive NPV. They can take it further and calculate the ENPV for the ball department by discounting the NPV back one year and yielding an ENPV of $88,254.

Lincoln Sports can see that a successful market testing benefits the company as the Full Production of new cleats will bring in more profit than the Limited Production, which only yields a positive NPV in the optimistic scenario without the ball department implemented. For the company to generate the ENPV of the entire project, assuming a base case scenario, they would simply add the ENPV of the ball department, $88,254, and the ENPV of both productions of new cleats, $192,662 to generate a project ENPV of $280,916. With these numbers n front of them, Lincoln Sports can decide to discontinue the old cleats and invest in the ball department, as it adds value to the company.

Conclusion

The Lincoln Sports Management Team should investigate the New Cleat project only if the new cleat launch is successful. If it is not, limited production only provides a positive NPV value if it is the most optimistic market scenario and if there is no ball department. They would be calculating the sunk cost if they continued with the limited production of the new cleat costing Lincoln Sports more money. The cost of goods sold for the full production of the new cleat is based at 64% of sales or $17.92 per cleat leading to a profit of $10.08 per cleat. With a limited projection, it does also increase the cost of goods sold to 67% or $18.76 per cleat with a profit of $9.24, this causes a loss of $0.84 per cleat from full to limited production per cleat. This is also on top of the differences in units sold. So, if the new cleat is not successful it would be better to reevaluate the project from that time point and think about other projects that may better help Lincoln Sports.

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IvyPanda. (2021, July 6). Lincoln Sports Equipment: Capital Budgeting. Retrieved from https://ivypanda.com/essays/lincoln-sports-equipment-capital-budgeting/

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