Financial Management Case Study Report: Hillside Industries Analysis

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FINANCIAL MANAGEMENT
CASE STUDY REPORT
2/12/2020
STUDENT’S NAME:
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Contents
Introduction...........................................................................................................................................2
Working capital decisions.....................................................................................................................2
Forecasted sales and productivity..........................................................................................................3
Evaluation of the project proposal.........................................................................................................4
Methods of financing and the resulting impacts....................................................................................6
Conclusion.............................................................................................................................................8
References.............................................................................................................................................9
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Introduction
Few important aspects of the financial management in an organisation are that of the
decisions related to the working capital, investing and the financing. The senior management
of an organisation is required to consider the various factors involved, and making informed
judgements, because the above mentioned decisions are not only irreversible, but also involve
huge amount of investments (Ross et.al, 2014). The aim of the following report is to guide
the management of the company Hillside Industries regarding the various aspects of the
financial management decisions. The first part would involve the evaluation of the working
capital decision, followed by the analysis of the cash and the accounting break even points.
The latter part would involve the evaluation of the project proposal using the NPV method,
and the analysis of the cost of capital and financing structure.
Working capital decisions
Working capital decisions are one significant business decisions and deals with the day to day
working of the entity. The efficient decisions ensure that there are sufficient short term assets
for the fulfilment of the short term obligations (Brigham and Ehrhardt, 2013). In the given
case study, the management is contemplating the increase of the debtor turnover period from
15 to 30 days, as suggested by the marketing department of the entity. The said move is
suggested to increase the demand of the products by the ease of the payment terms to the
debtors. However, there may be serious implications of the said increase which are elaborated
as follows.
Cash conversion cycle is referred to as a metric that aids in the measurement of the time
(generally in number of days) taken by the company to convert its current resources such as
inventory and debtors into cash (Rὂhrich, 2014). Thus, the company’s operational and
managerial efficiency is gauged through the said metric. The formula for the cash conversion
cycle is stated as follows.
CCC = DSO + DIO – DPO
Where,
DSO = Daily sales outstanding or the Average Collection Period
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DIO = Days of inventory outstanding
DPO = Days of payable outstanding or the Average Payment Period
The DSO refers to the number of days taken by the company to release the cash from the
debtors. Thus, the efficiency of the collection of cash from the sales of the company is to be
calculated in this part of the cash conversion cycle. The formula for the calculation of the
Daily Sales Outstanding is listed as follows.
Here,
Average Accounts Receivable = ½ * (Beginning Accounts Receivable + Ending Accounts
Receivable)
It is desired by the managers of an organisation to reduce the value of DSO, because of the
importance of the cash in the running of the business and the concept of the time value of
money, which means money collected sooner by a business, is of more value than the money
collected later (Scott, 2012). This is because of the ability to earn interest on the funds.
Thus, the increment of the number of days in the payment period from 15 days to 30 days,
would lead to the increment in the daily sales outstanding. The result of the same would be
increment in the overall cash conversion cycle. This can lead to the issues of liquidity crunch
in the organisation, where the entity is not having enough cash for the payment of debts.
Forecasted sales and productivity
Breakeven analysis is one of the most significant tools to evaluate the vitality of a business
decision as it highlights the impact of the same on the productivity in terms of the units to be
produced and the revenues to be charged therein, to cover the fixed and the variable costs.
Thus, the relationship between the fixed costs, variable costs and the revenues is analysed.
The breakeven point has two variations in the form of the accounting break-even point and
the cash breakeven point, which are described as follows.
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The accounting breakeven point denotes the point of productivity where the total revenue is
equivalent to the total costs in the production. Thus, it is that levels of sales at which zero
profit is generated. The accounting break-even point is calculated on the basis of the accrual
concept of accounting, and it is assumed that the fixed costs that belongs to the period that are
the salaries, rent and interest expenses would be considered irrespective of the fact that the
same are paid in cash or not.
In contrast to the above, the cash break-even point calculation involves the consideration of
only those fixed costs that have been incurred in cash. Since, the timing of expense
recognition is different in both the approaches; the break even points would be separate from
each other in both the calculations. The following is depicted accounting break even points
for the organisation Hillside Industries.
Computation of the break even
point
Description Units Rate Amount in $
Projected sales units
$20,000.0
0
$
100.00
$
20,00,000.00
Variable costs
Material Costs
$20,000.0
0
$
30.00
$
6,00,000.00
Contribution Margin
$
70.00
$
14,00,000.00
Contribution margin percentage 70%
Fixed Costs (Advertisement Campaign)
$
40,000.00
Net Profits
$
13,60,000.00
Breakeven point = Fixed costs/ Contribution margin
Breakeven point = 40000/70
Breakeven point = 571.43
Breakeven point = 572 units
Hence, as computed above, it would take 572 units to cover the fixed expenses in the form of
the advertisement charges to be paid in the cash. The cash breakeven point would also be the
same, because of the absence of the information of the other expenses and the mode of the
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payments. Accordingly, it has been suggested to accept the proposal of the new technology
which would raise the demand of its products in the market, and thus ensure that the
production facilities are not lying idle.
Evaluation of the project proposal
There are various financial management techniques for the evaluation of the project proposals
such as Pay Back Period, Accounting Rate of Return, Internal Rate of Return, Profitability
Index and others (Arnold, 2012). The Net Present Value Method is regarded as the superior
of all due to various reasons. The explanation of the technique, the significance of the same,
and the project proposal evaluation using the said technique is presented below.
Net Present Value refers to the net amount of the present values of the varied cash flows
occurring out of a project, at various points of time. The first step involved is the estimation
of the cash flows that would arise because of the proposal in question and define a stream of
cash flows (Baker and English, 2011). The next step involves the determination of an
appropriate discount rate by the management of the entity. The said determination involves
the consideration of different factors in the business environment of the organisation. The Net
Present Value is computed using the formula as stated below.
NPV =
i=1
n CFi
(1+d)i
= CF0 + CF1
(1+k )1 + CF2
(1+k )2 + …. + CF3
(1+k )3
where:
CF0 = initial investment,
CFi = net cash flow from year i,
n = number of years, and
k = discount rate or the cost of capital
The above technique can be used for the evaluation of a single project as well as the mutually
exclusive multiple projects. For a single project to be selected based on the above formula,
the NPV computed of the project should be positive (Gray, Larson and Desai, 2011). In the
case of several mutually exclusive projects, the one witht the highest positive NPV project is
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chosen (Brigham and Houston, 2012). The following is depicted the NPV calculation of the
project for the consideration of the board of directors of Hillside Industries.
It is important to note that the hurdle rate or the cost of capital has been taken to be 6.48 %,
which is the weighted average cost of capital of the debt and equity components of the
organisation Hillside Industries.
Description Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Totals
Investment (2,70,0
00)
- - - - - (2,70,00
0)
Annual cash
flows
- 4
7,000
6
1,000
95
,000
9
7,000
1,50
,000
Net Cash Flow (2,70,0
00)
4
7,000
6
1,000
95
,000
9
7,000
1,50
,000
1,80,0
00
PVF @ 7.37% 1.00 0.94 0.88 0.83 0.78 0.73
Discounted
Cash Flows
(2,70,0
00)
4
4140
5
3801
78
690 75457 109585
Hurdle Rate 6.48%
NPV=
Net Present
Value (=NPV)
$ 91673
Computation of WACC
Ratio of liability = 0.6
Ratio of equity = 0.4
WACC = (11%*0.4) + (3.47%*0.6)
WACC =
6.48
%
As the NPV computed iis positive, it is suggested to the management and the Board of
Directors of the Hillside Industries to accept the project proposal.
The said method has been used for the evaluation of the fully automated production
technology for the new plant, on the lines of expansion. The rationale behind the adoption of
the said method for the evaluation of the proposal is the numerous advantages of the
techniqie over others, as listed below. The prime advantage of the usage of the NPV is that
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the same is considerate of the time value of money concept, unlike in the Pay Back Period.
The concept of time value of money is significant to be considered in the proposal evaluation
as well, to determine the real cash flows occuring from a project. The yet another major
benefit of the usage of the Net Present Value method is that the results are in absolute terms,
that is either a positive or a negative NPV, unlike in the Internal Rate of Return Method
(IRR), where a project can have more than one IRR. Thus, in the case of the multiple IRRs,
the selection of the project becomes difficult. The said issue is avoided in the NPV method.
The method has further advantage of being the absolute measure of profitability, as all the
cash flows are considered, that the ones even occuring after the life of the project (Goyat and
Nain, 2016). Further to state, that sunk costs are avoided in the said computation, and thus the
results derived from the said technique are realistic. Hence, the above advantages of the NPV
method, makes the method suitable for the evaluation as conducted in the previous parts.
Methods of financing and the resulting impacts
Financing decisions are one of the key decisions of management of an enterprise. These
decisions must be consiously taken after taking into consideration of the various factors
involved. There are primarily two sources of finance that are debt and equity, and each of the
above have their own shares of pros and cons. The following is depicted, the computation of
the cost of equity and the cost of debt, and the analysis of the same in relation to the Hillside
Industries.
Computation of cost of equity
Rf = 1%
Beta = 2
Rm = 6%
Ke = 1% + 2*(6%-1%)
Ke = 11.00%
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Computation of cost of debt
Coupon = 40
Face Value = 1000
Price = 896
n = 15
Kd = (40 + ((1000-896)/15))/((1000+896)/2)
Kd = 4.95%
After tax Kd = 3.47%
Thus, as computed above, the cost of equity has turned out to be 11 percent as per the Capital
Asset Pricing Model. In contrast to this, the cost of debt has been computed to be 3.47%.
Thus, it is evident that the cost of debt is lower as computed with the aid of the yield to
maturity (YTM) formula. Apart from the lower cost of debt financing, there are certain other
disadvantages as well for the debt financing of the project. The prime advantage is that there
is no dilution of control as in the case of the new equity issues. The existing owners would be
able to retain the control over the company operations and the management of the affairs. In
addition, there is tax benefit derived on the amount of interest to be paid on the debt
financing. Thus, as computed above, the cost of debt was computed to be 4.95 %, however
the tax rate of 30 per cent decreased the cost of debt even more. Thus, the after tax cost of
debt has been computed to be 3.47 percent. It is evident that the overall cost of capital has
reduced significantly with the inclusion of debt financing. Accordingly, the board of directors
of the organisation Hillside Industries are suggested to avail debt financing for the said
proposal. This would keep the overall cost of capital on a lower level and would be beneficil
for the entity in terms of the retention of the control of affairs as well.
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Conclusion
The discussions conducted in the previous parts aid in the conclusion that it would be
beneficial to accept the proposal in question for the organisation Hillside Industries. The
report involved the analysis of the various financial management aspects such as that of
workin capital management, captial financing structure, and the cash and accounting
breakeven points. The future cash flows are further analysed in the light of the Net Present
Value method, and accordingly it has been suggested to accept the proposal. It is further to be
noted that the increase in the average payment period can lead to the cash crunch in the
entity, and thus the same must be taken care of for the management of the day to day
operations and the currernt obligations. Further, it has been recommended to issue bonds or
avail long term loan for the financing of the said project, so as to reduce the overall cost of
capital, and also that it is the cheaper source of financing in comparison to the equity.
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References
Arnold, G. (2012) Corporate financial management. UK: Pearson Education.
Baker, H. K., and English, P. (2011) Capital Budgeting Valuation: Financial Analysis for
Today's Investment Projects. New Jersey: John Wiley & Sons Inc.
Brigham, E. F. and Ehrhardt, M. C. (2013) Financial management: Theory & practice.
Boston MA: Cengage Learning.
Brigham, E. F., and Houston, J. F. (2012) Fundamentals of Financial Management. Boston
MA: Cengage Learning.
Goyat, S., and Nain, A. (2016) Methods of Evaluating Investment Proposals. International
Journal of Engineering and Management Research (IJEMR), 6(5), p. 279.
Gray, C. F., Larson, E. W., and Desai, G. V. (2011) Project Management. The Managerial
Process. 4th ed. New Delhi: Tata McGraw Hill Education Pvt. Ltd.
Ross, S. A., Westerfield, R. W., Jaffe, J., and Kakani, R. K. (2014) Corporate Finance. 8th ed.
New Delhi: Tata McGraw Hill Education Pvt Ltd.
Rὂhrich, M. (2014) Fundamentals of Investment Appraisal: An Illustration based on a Case
Study. Boston: Walter de Gruyter GmbH & Co.
Scott, P. (2012) Accounting for Business: An Integrated Print and Online Solution. Oxford:
Oxford University Press, p. 342.
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