2. Case Analysis

Please read the following cases carefully and answer the questions followed.

It had taken countless hours of work, but on August 12, 2018, Stewart and Marilyn were finally ready to give their presentation to Tyler and Lilly. After gathering everyone in the large conference room, they began by explaining the process through which they had just gone.

"We know roughly how many of each product is currently demanded." Stewart said after everyone was settled. "From that, we estimated future demand using trend analysis, incorporating seasonal variations, increased productivity potential, and the significantly larger market presence. We did this for each product and merged the results to find the total additional revenue that can be expected from the additional plants. The marketing department aided considerably in helping to gauge demand. And to be honest, we will be receiving large bills from statisticians that were called in for consultation."

He and Marilyn were at front and center of the conference room. Tyler and Lilly took the first two seats. Jane sat to Tyler's right, while Brandon sat on Lilly's left. Dubarb Freeman held court at the far end of the table, along with Coleman, who was there in case there were questions pertaining to the accounting statements. When a platoon of administrative assistants and various representatives from other areas were added to the mix, the room was full. Several lower-level employees were relegated to the standing room only at the back of the room. The table was littered with piles of reports detailing the data Marilyn and Stewart had compiled. They had assembled the primary findings in a PowerPoint presentation but had hard copies on hand in case a more extensive review was requested.

"We started just by trying to get a handle on the type of project we want to consider." Marilyn continued. She had dressed carefully for the day, wearing a conservative yet sophisticated black suit by St. John paired with Jimmy Chooheels. Stewart's off-the-rack dark gray suit seemed utilitarian next to her, but he didn't seem to mind.

"The largest issue Hack Back is currently facing is the lack of manufacturing facilities," Marilyn continued. "As Mr. Freeman has put forth, we need at least two more major facilities in order to cope with the excess demand we are now experiencing. So, our goal is to identify the option that best balances cost efficiency with revenue production. And, of course, the end result should be to add value to the firm and its shareholders."

Stewart and Marilyn spent the next half hour detailing the process they went through in identifying potential locations and plant designs. They fielded a number of questions but in the end had everyone on the same page and ready to move on.

"When all is said and done," Stewart added, "we have obtained what we believe are reasonable estimates for the revenues, costs, and profits of the potential projects."

Marilyn reached over the computer console to fiddle with opening the presentation. "What you will see is that we have identified two distinctly different plant designs. There is a large push in the sporting goods industry to move to a more automated production process. The first plant design lends itself to this purpose. The proposal is a relatively small structure, which houses a more streamlined process that requires considerably less manual labor. Based upon our current production rates and, hopefully, improvement in them, we believe costs at those plants will be approximately 55 % of sales."

"That is considerably less than where we are as a firm now," Coleman commented, just barely loud enough to rattle the paintings on the wall.

"This is very true," Marilyn agreed. "Naturally, however, the machinery required at this plant will cost more than traditional plants and will need more regular maintenance. These 'high-tech' plants would remain up to date for fifteen years before basically needing complete renovation. Therefore, for the sake of argument, we are treating it as a fifteen-year project."

She paused to catch her breath before continuing.

"The extensive research that we described earlier has led us to the belief that each new plant would generate additional revenue of approximately $15.7 million per year. For both plants combined, that would be a projection of an increase of a bit less than 8 % over last year's firm-wide revenues. In addition to the added revenue, it should also allow our existing assets to more efficiently generate income, which we have identified as a current shortcoming."

Stewart spoke up. "Rather than look at differing levels of projected sales over numerous years, we chose to project each year's sales figure as constant. This is admittedly a restrictive assumption, but we feel it provides the cleanest up-front look. That way, we can also estimate the same level of costs for each year. We will, naturally, evaluate other specifications before making a final decision."

He nodded slightly to Marilyn, who took the queue and maneuvered the mouse for a moment. A slide appeared on the overhead projection screen.

"So, you believe each plant will generate revenues of two hundred and thirty-five million and profit of over sixty-five million over the fifteen years?" Lilly asked, after punching buttons on a small calculator in front of her. She was strenuously opposed to doing math in her head.

"That's certainly one way to look at it, but there are a couple of caveats to hat," Marilyn responded.

"Such as?"

"Let me take that, if I may," Freeman responded, standing and walking to the front of the room. Lilly and Tyler whirled in their seats to follow his movement.

"The first thing we must do is look at cash flows rather than income figures, since I believe we all agree that what matters is how much money is actually expected to flow into and out of the firm as a result of taking on this project. Right ?"

"I suppose so," Tyler said. Turning to Stewart and Marilyn, he asked, "so what are the cash flows?"

"Based upon the projected statement, it appears each high-tech plant would generate a bit over $4.7 million per year in operating cash flows," Stewart responded. "That can roughly be defined as the amount of money expected to flow into the firm as a result of the production and selling of products made in each plant.

"So now you're saying we would make over $70 million over the fifteen years?" Lilly said, again clicking away at her calculator.

"That brings about the other caveat," Freeman said, holding up an open palm to halt her train of thought. "These cash flows are coming at different times in the future. So we have to worry about that as well. Suffice it to say, however, this project is not worth $70 million in current value. And before you ask how much it's really worth, I don't know. We have to do a lot more work before we get to that. What you should be asking is how much it costs?"

"Okay, I'll bite," Tyler said. "How much does it cost?"

"Well, that's the other thing," Freeman again cautioned. "There are two ways of thinking of the costs of the project. Probably the more important is the ongoing cost associated with obtaining the capital we need to finance the projects. That is the hard part that I was just mentioning. We have to figure out how we are to obtain the funding and then think about the costs of that attainment." He paused and held up both open palms to the room.

"But, that is likely not the cost you are referring to," he said, emphasizing the word "cost" with air quotations. "You are likely asking about the amount of money it would take to get the project up and running, in other words the initial costs. We call that the net investment."

"Okay, I will again bite," Tyler said again. "What is the net investment?"

This time, Freeman simply nodded to Marilyn, who then clicked to the next slide and pointed out details as she spoke.

"We estimate the land would cost around $3 million. The architectural firms that provide the estimates say the plant itself would cost around $12 million. The other equipment needed would add about another $3 million." "So, all together it costs $18 million," Lilly stated.

"That is the estimate for net capital spending we are currently working with," Stewart stated.

"We're not quite done though," Freeman interjected. He still stood but was now leaning on the edge of the table with one trouser leg hiked up mid-calf. It was a pleasant view.

"WealsoestimatethatwewillberequiredtoincreaseNWC

by $5 million dollars in order to run this plant," he added. "We might get that back at the end, but nonetheless, we have to spend it throughout the project to maintain operations with an acceptable level of risk." "Net working what?" Lilly questioned.

"We'll explain later," Freeman said, waving off her question "For now, here's what we know. The initial total cost of the high-tech plant is approximated at $23 million. For the sake of making it simple for this presentation, for now we've assumed the cost of the plant and equipment can be depreciated as business property over 39 years. In actuality, each depreciable asset will have to be considered separately, according to their class. Thus, the depreciation estimates presented here are underestimating the amount of depreciation, at least up front. The land can't be depreciated at all, of course."

"Of course. I'm glad we're making it simple," Lilly said, not attempting to hide her sarcasm.

"You said there were two plant options," Tyler jumped in, deflecting Lilly's scorn.

"There were hundreds of options," Freeman responded unnecessarily, "but we've narrowed it down to two."

"Well, the other option is a more traditional setup," Stewart jumped in diplomatically. "The building will have to be larger, with more employees required to run it. However, the equipment will be considerably cheaper and will last longer. Since we are dealing with a project less dependent on technology, the materials will not have to be replaced as often. In fact, we feel the traditional plant will run for 20 years before becoming largely obsolete."

"We firmly believe both plants can meet demand, and both can generate the same revenue as a result. However, this option will do it a bit less efficiently, as evidenced by the pro forma statement. The annual costs are estimated at 65 % of sales."

He cast a glance in Coleman's direction before adding, "Which is still a lot lower than we are currently operating at, firm-wide."

"Therefore, we expect operating cash flows of about $3.66 million each year," Marilyn added. "So cash inflows are expected to be less, but so too are costs. As mentioned, the machinery and other materials required in the traditional building are less expensive. The land will cost the same $3 million, but the plant and equipment will only be about $10 million in total. Also, we estimate net working capital has to increase by only approximately $3 million."

"So here you have it, kids," Freeman boomed. "Two plants we need built and two options for the type we can build. Marilyn, put those other slides up." Marilyn obliged and the group turned to see the summary.

"Above is a brief summary, and this," she paused to move the presentation forward, "is a little better idea of what the cash flow schedule looks like."

"Now let me tell you a bit more about the assumptions we made here," Marilyn continued. "First of all, if we are going to build these things, we plan to use them forever. However, for now we are only looking at the 15- and 20-year projects because that's when we would have to think about serious overhaul. Such a serious overhaul would then be evaluated as a new project for Hack Back to consider.

We don't plan, at this time, to sell the plant or equipment, and that's the reason we don't have any NCS money coming back to us at the end. That may change if we decide to sell some stuff, but we won't deal with that now. You can also see that we are assuming that we get the entire change in NWC back at the end, which also may not happen, but it is the simplest scenario when examining a standalone project."

The room fell eerily silent as everyone tried to take in the immense amount of information given them. Assistants tried to look busy while doodling on their notepads and avoiding direct stares.

"This is a pretty big piece of the puzzle that has been put before you, but we have really just started," Freeman cautioned the owners. "We have to take those numbers and make sense of them on many levels." He then straightened from this perch.

"Marilyn, Stewart, go back through whatever they need again."

With that, he zipped out of the room, leaving everyone watching the empty doorway.

"How does he always manage to get to say the most important stuff just before making a grand exit?" Stewart asked, without thinking. As the entire room chuckled, Stewart couldn't hide a slight blush.

"You'll get used to it," Tyler responded, with a wave of his hand. "Now let's go over these numbers again."

"Much more slowly, please" Lilly added. The assistants sighed silently as the bosses bent toward the table.

Questions:

(1) Help Stewart and Anna out. Suppose they didn't choose to make the easy assumption that all years have equal sales amounts. What happens then?

(a)Describe the various complications that arise and how they must be dealt with.

(b)As an example, instead of assuming sales were going to be the same each year, assume the extensive research Hack Back put into the pro formas indicating sales would increase by $325,000 each year, starting with the $15,700,000 for the first year.

How does this change the projected net income and operating cash flow each year?

Warning: This requires quite a bit of work. Keep in mind that you must create income statements for each of the 15 and 20 years for the high-tech and traditional plants, respectively.

A bit of advice: Use Excel!

(2)Now, believe it or not, it actually can get worse. For example, what if we added the assumption that NWC was a direct function of the sales figure? The implicit assumption in the base problem (where sales are a constant $15.7 million each year) is that NWC is 31.85 % (5,000,000/15,700,000) of sales for the high-tech project. If we keep this as a constant percentage, it would make the extended example just above (#1) more difficult because as sales increase, NWC would have to increase as well. Why not add that to your spreadsheet and see what happens? Also, what about the assumption that the firm gets the entire increase in NWC back at the completion of the project? Discuss situations where that may or may not be a logical assumption, and consider the resulting implications if changes to the assumption need to be made.

(3)Suppose that the firm gets more specific in their treatment of depreciation. In the current problem, the firm is projecting to depreciate all depreciable assets as long-term physical property. However, that will not actually happen, as things such as computers or vehicles are shorter-lived assets. Discuss how this would change the analysis. Remember that a high-tech project will have a lot of computerized equipment that might be shorter lived. How might that effect the decision between the two?

(4)Speaking of depreciation, what happens to the remaining depreciation after the 15 and 20 years are up? More generally, what happens to the remaining depreciation anytime you have book value remaining following the completion of the use of the asset? What are your options?

(5)How about something else to think about? What would happen if Hack Back decided at the end of the project to sell off at least some of the assets they bought with the NCS? As a hint, the answer would be related to our discussion of the relationship between book values and market values.

(6)Suppose Tyler makes the following statement: "It seems like this may be a lot of work for only an 8 % increase in revenues. Can you give me any more substantiation for why this project will significantly help Hack Back?"

This is a very good (and popular) boss-type question. How do you answer it?

(7)After the assertion of the need for additional NWC to fund the projects, Lilly asked another very good question: "I don't get it. Where does that value come from mechanically? Do we buy more assets, reduce liabilities, or what? More importantly, why do we need to do these things?" The answer to this question requires you to have an understanding of the role of additional risk brought about by the new project and the firm's response to this increasing risk.

(8)In a somewhat unrelated issue, complete Hack Back's cash flow identity. The financial statements can be found in the statements at the end of the text. What do the numbers tell you about Hack Back?

Hack Back's 2016 and 2017 Financial Statements

Hack Back, Incorporated

Income statement for years ending Dec. 31, 2016 and 2017

2016

2017

Sales

327,890,500

402,456,525

Cost of goods sold

244,606,313

324,599,611

Depreciation

37,435,864

41,385,900

EBIT

45,848,323

33,471,014

Interest

1,743,800

2,015,435

Taxable income

44,104,523

21,455,579

Taxes (35%)

15,436,583

11,009,453

Net income

28,667,940

20,446,126

Dividends

2,400,000

5,040,000

Addition to retained earnings

26,267,940

15,406,126

Hack Back, Incorporated

Balance sheet as of Dec. 31, 2016 and 2017

Assets

Liabilities

2016

2017

2016

2017

Current assets

Current

liabilities

20,435,135

27,349,500

Cash

37,970,869

51,581,987

Long-term debt

28,197,000

30,125,346

A/R

17,976,050

19,341,907

Total debt

48,632,135

57,474,846

Inventory

102,987,500

140,891,891

Total current

158,934,419

211,815,785

Equity

Common stock

223,200,000

223,200,000

Fixed assets

147,505,203

118,572,674

Retained earnings

34,607,487

50,013,613

Total equity

257,807,487

273,213,613

Total assets

$306,439,622

$330,688,459

Total

liabilities

& equity

$306,439,622

$330,688,459

(Please submit the Final Integral Exercise before the date of May 20, 2020.)

Following isAttachment