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Keeping Score: Financial Analysis and Performance Metrics

Cannibalization Analysis

What is Cannibalization?

Cannibalization results when the sales of a new product in part come from sales taken away from other products sold by that firm. Cannibalization most commonly occurs when a firm introduces a new flanker brand or line extension into the same product line in which it already has brand representation. For example, when Proctor & Gamble introduces a new brand of laundry detergent into its extensive line of detergents, some sales for the new brand will highly likely come at the expense of one or more of P&G’s existing brands of laundry detergent. In other words, the sales of P&G’s existing brand of laundry detergents will be cannibalized to support sales of the new brand.

The effects of cannibalization can be good or bad, depending on the overall effect on profitability for both the new brand and the cannibalized brands. Determining the effects on profitability are relatively easy. Let’s examine a simple example of how it works. Assume two brands of mouthwash produced by the same firm (P&G?). Relevant price and cost data for these brands are below. Brand A is currently sold at $1.00 per unit with associated variable costs per unit of $.60. Brand B, the new brand to be introduced, sells for a little less, say $.95 per unit. Its costs per unit are the same as for Brand A i.e. $.60 per unit. Note that the resulting unit contribution for Brand B (price minus unit variable costs) is $.35 which is $.05 less than the unit contribution for Brand A. This means that for each unit of Brand A that is cannibalized by Brand B, the firm loses $.05 in contribution.

Assume that management anticipates that when Brand B is launched, 20% of its sales will come from sales that would have been for Brand A. In other words, 20% of Brand B’s sales will be cannibalized from the sales of Brand A. The net effect of this cannibalization on profits is easily found by comparing the contribution (gross profit) assuming Brand B is not launched (and therefore no cannibalization occurs) with the contribution (gross profit) expected from the launch of Brand B with the expected level of cannibalization.

Here is how the analysis proceeds. First, compute the expected contribution from the sales of Brand A with no cannibalization (i.e. Brand B is not launched). Assume that Brand A’s sales without the introduction of Brand B are expected to be 1,000 units. Since the unit contribution for Brand A is $.40 per unit, the overall resulting contribution (gross profit) will be 1,000 x $.40 = $400.00. Easy!

Next, compute the expected contribution dollars assuming that Brand B is launched and the expected level of cannibalization occurs. Here is how this part proceeds. Assume that Brand B is expected to sell only 500 units initially and that 20% of these sales will come from Brand A (i.e. 20% of 500 equals 100 units that will be cannibalized from Brand A.). The table below summarizes the computations. Since 100 units will be cannibalized from Brand A’s sales, the brand will now sell only 900 units. Since the profit per unit (unit contribution) is $.40, the resulting total contribution dollars from the sales of Brand A will be 900 x $ .40 = $360.00. Brand B is expected to sell 500 units in total, with 100 of these units being cannibalized from Brand A. Therefore, Brand B’s contribution dollars will be 100 units x $.35 = $35.00 plus 400 units x $.35 = $140.00 for an overall contribution of $535.00.

The net change in contribution dollars if Brand B is introduced is $535 - $400 = $135. Thus, contribution dollars are expected to increase by $135 with the addition of Brand B to the product line of mouthwashes. Should the new brand be launched? The answer is clearly YES. Had overall contribution dollars declined due to cannibalization then the decision would have been NO.

You should also be aware by now that cannibalization will only be problematic, potentially reducing dollar contribution, if the unit contribution for the new product is less than the unit contribution for the old product. The greater the difference between the unit contributions the greater the impact will be of any cannibalization of the old brand by the new brand. You can verify this for yourself if you have built a spreadsheet to run your calculations.

Now It’s Your Turn. Show Us What You Have Learned.

Returning to our running case for Shannon’s Brewery introduced in the market share exercise, assume that Shannon’s is considering the introduction of a new craft beer called Irish Stout that will be derived from its award winning Irish Red. Initially, Irish Stout will only be sold “on premise” at the brewery. Currently, pints of Irish Red consumed on premise sell for $5.00 per pint with unit variable costs of approximately $2.75 per pint. Variable costs are predominantly comprised of the costs of ingredients and utilities that directly affect the brewing process. The new craft beer will be positioned at a slightly higher price, $5.25 per pint and its unit variable costs will be about $3.25 due to the higher cost of some ingredients. The relevant price, cost, and margin data are below.

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Question 1

Shannon’s Irish Red averages on premise sales of 1,200 pints per month. What is the anticipated profit (contribution dollars) per month associated with sales of Shannon’s Irish Red assuming that the Irish Stout is not introduced. Express your answer to the nearest dollar. Do not include the dollar sign.

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Question 2

Assume that Shannon’s estimates that the sales of the new Irish Stout will be about 250 pints per month, but 25% of these sales will be cannibalized from sales of Shannon’s Irish Red. Compute the total combined increase in contribution dollars for both Irish Red and Irish Stout expected with cannibalization . Express your answer to the nearest dollar. Do not include the dollar sign.

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Question 3

1. Let’s stretch a little on this one. Assume Shannon’s Irish Red sells 1,000 pints per month in the absence of any cannibalization. Assume also that the new Irish Stout will sell 500 pints per month. The relevant price and cost data are:

What will be the maximum percentage cannibalization that can exist before the overall change in contribution dollars becomes negative? Express your answer in percentage form to the nearest percent e.g.; 99.49% rounds down to99%; 99.50% rounds up to 100%. Do not include the % symbol.

WSP Inc. is involved in a wide range of unrelated projects. The company will pursue any project that it thinks will create value for its stockholders. Consequently, the risk level of the company’s projects tends to vary a great deal from project to project.

If WSP Inc. does not risk-adjust its discount rate for specific projects properly, which of the following is likely to occur over time? Check all that apply.

The firm will accept too many relatively safe projects.

The firm will accept too many relatively risky projects.

The firm will become less valuable.

Generally, a positive correlation exists between a project’s returns and the returns on the firm’s other assets. If this correlation is   , stand-alone risk will be a good proxy for within-firm risk.

Consider the case of another company. Chrome Printing is evaluating two mutually exclusive projects. They both require a $1 million investment today and have expected NPVs of $200,000. Management conducted a full risk analysis of these two projects, and the results are shown below.

Which of the following statements about these projects’ risk is correct? Check all that apply.

Project B has more corporate risk than Project A.

Project B has more market risk than Project A.

Project A has more corporate risk than Project B.

Project B has more stand-alone risk than Project A.

A potential new project would cost $1000 today. The 1st stage of the project would last 2 years. There are 2 possible scenarios for Stage 1 net cash flows in years 1 and 2: 1) $1,060 per year, with 50% probability; or 2) $0 per year, with 50% probability. If the 1st stage outcome is good (with non-zero outcomes), the firm will reinvest an equal amount in year 2 (the same amount invested at year 0) and extend the project into Stage 2 (years 3 and 4). The possible Stage 2 outcomes are either: 1) net cash flows in years 3 and 4 doubling relative to the good Stage 1 outcome (with probability of 50%), or 2) net cash flows of 0 in years 3 and 4 (with probability of 50%). If the Stage 1 outcome is bad, the firm will abandon the project at the conclusion of Stage 1.

The cost of capital is 9%. The overall expected NPV of the project (at year 0), considering Stage 1 and the option to expand the project into Stage 2, is $_______.

You have just taken out an $18,000 car loan with a 6% ​APR, compounded monthly. The loan is for five years. When you make your first payment in one​ month, how much of the payment will go toward the principal of the loan and how much will go toward​ interest?

QUESTION

When you make your first​ payment, ​$????? will go toward the principal of the loan and ​$???? will go toward the interest

How much must you invest today at 6% interest in order to see your investment grow to $8,000 in 10 years?

 You would like to have ​$50,000 in 12 years. To accumulate this​ amount, you plan to deposit an equal sum in the bank each year that will earn 10 percent interest compounded annually. Your first payment will be made at the end of the year. a.  How much must you deposit annually to accumulate this​ amount? b.  If you decide to make a large​ lump-sum deposit today instead of the annual​ deposits, how large should this​ lump-sum deposit​ be? ​ (Assume you can earn 10 percent on this​ deposit.) c.  At the end of five​ years, you will receive ​$15,000 and deposit this in the bank toward your goal of ​$50,000 at the end of year 12. In addition to the​ lump-sum deposit, how much must you deposit in equal annual​ amounts, beginning in year 1 to reach your​ goal? ​ (Again, assume you can earn 10 percent on your​ deposits.)

HMK Enterprises would like to raise $10.0 million to invest in capital expenditures. The company plans to issue​ five-year bonds with a face value of $1,000 and a coupon rate of 6.50%

​(annual payments). The following table summarizes the yield to maturity for​ five-year (annual-payment) coupon corporate bonds of various​ ratings:

Rating    AAA AA A    BBB    BB

YTM    6.20%    6.30% 6.50% 6.90% 7.50%

a. Assuming the bonds will be rated​ AA, what will be the price of the​ bonds?

b. How much of the total principal amount of these bonds must HMK issue to raise $10.0

Can you please provide the steps needed to reach the answer?

million​ today, assuming the bonds are AA​ rated? (Because HMK cannot issue a fraction of a​ bond, assume that all fractions are rounded to the nearest whole​ number.)

c. What must be the rating of the bonds for them to sell at​ par?

d. Suppose that when the bonds are​ issued, the price of each bond is $959.54. What is the likely rating of the​ bonds? Are they junk​ bonds?

a. Assuming the bonds will be rated​ AA, what will be the price of the​ bonds?

The price of the bonds will be? (Round to the nearest​ cent.)

Q10

St. Johns River Shipyards is considering the replacement of an 8-year-old riveting machine with a new one that will increase earnings before depreciation from $24,000 to $48,000 per year. The new machine will cost $90,000, and it will have an estimated life of 8 years and no salvage value. The new machine will be depreciated over its 5-year MACRS recovery period; so the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. The applicable corporate tax rate is 40%, and the firm's WACC is 16%. The old machine has been fully depreciated and has no salvage value.

What is the NPV of the project? Negative value, if any, should be indicated by a minus sign. Round your answer to the nearest cent.
$  

Should the old riveting machine be replaced by the new one?

Problem 3-5

Axtel Company has the following financial statements.

In addition, Axtel retired stock for $1,000,000 and paid a dividend of $1,727,000. Depreciation for the year was $1,036,000. Construct a statement of cash flows for Axtel for 20X1. (Hint: Retiring stock means buying it back from shareholders. Assume the purchase was made at book value, and treat it like a negative sale of stock.) Enter your answers in thousands. For example, an answer of $200 thousands should be entered as 200, not 200000. Use a minus sign, to indicate any decreases in cash or cash outflows.

Yasser Ben Rashid must earn a minimum rate of return of 12% to be adequately compensated for the risk of the following investment:

Initial Investment $16,000

End of Year Income   

   1 $7,000

   2 $4,000

   3 $6,000

   4 $3,000

   5    $3,100

a. Estimate the IRR on this investment.

b. On the basis of your finding in part a, should Yasser make the proposed investment? Explain.

true/false
1. Financial leverage index = return on equity/return on assets
2. Market to book ratio = stock price/earning per share
3. Total return to shareholders = stock price appreciation .
4. Working capital turnover measures inventory management.