Question

Nathan Quinlivan, the Demand and Strategy Finance director for Saturn Petcare Australia New Zealand, believes that Saturn needs to move away from the discounting model of driving growth and should develop new products in order to retain strong margin after conversion metrics. The company has conducted several rounds of independent research costing $500,000 and believes that a new ‘Buddy’ wet dog food product can be expected to achieve sales of AUD $20 million in the first year at $1.25 per can (unit sales of 16 million cans). Whilst unit sales are expected to remain at the same level, sales price over the life of the product is expected to increase at the long-term rate of inflation (estimated at 2.35%). Margin after conversion (gross profit) on the product is targeted at 30%. Raw materials and packaging costs vary directly with production and make up 50% of total manufacturing costs. The remaining manufacturing costs in the proposed hi-tech factory (including labour and utilities expenditure) will be 80% fixed costs and 20% variable costs. The budget for the first year of production estimates a gross profit (margin after conversion) of $6 million from the budgeted $20 million in sales. Manufacturing costs of $14 million can be broken up as $7 million raw materials and $7 million in conversion costs. Fixed conversion costs are estimated to be $5.6 million and variable conversion costs are $1.4 million ($0.0875 per unit in the first year). You have been asked to conduct a capital budgeting analysis of the viability of the proposed new ‘Buddy’ pet food range. Saturn have a global target return on investment of 20% pa. If Saturn proceed with this product launch a new manufacturing facility and production line with an annual production capacity of 28 million cans will be constructed at an estimated cost of $20 million. The new ‘Buddy’ product is being evaluated on the basis that it will have a 10 year product lifecycle. The new production facility will be depreciated on a straight line basis over the 10 year lifecycle to zero. Because of anticipated technology changes the production facility is expected to have a salvage value of $5 million at the end of 10 years. Saturn are an international company and pay Australian tax at the rate of 30% on profits. The capital budgeting analysis should be conducted on an after tax basis. Prepare an excel spreadsheet calculating whether this product will satisfy the investment parameters set by Saturn Group global. (i) Required: For the proposed ‘Buddy’ capital investment calculate the following: After-tax cash flows . Payback period . Net present value . Profitability index .

Answer 1

The product will not satisfy 20% of required return