Question

Analysis of South American Operations

Claire Jackson (CEO) of Easy Learning (EL) is considering discontinuing operations in South America, which are based in Argentina. For a variety of reasons it has been a challenge for EL to grow the busi- ness in this region and costs continue to rise because of high inflation. Results from the most recent fiscal year just ended are shown below.

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000

Variable expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $220,000

Fixed expenses .................................                               310,000

Operating income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . ($90,000)

If the South American operations are discontinued, Jackson has identified the following implications:

1.  Assets with an original cost of $485,000, mostly leasehold improvements and computer equipment, can be sold for $15,000. Assume that the assets are completely written off for both accounting purposes and tax purposes (i.e., $0 NBV and UCC) and that the salvage proceeds of $15,000 are not taxable. 


2. Severance pay for the three full-time employees will total $50,000. Severance pay is a tax deductible expense. 


3.  Of the total annual fixed expenses of $310,000, $40,000 represents an allocation from head office for computer support and will continue to be incurred even if the South American operations are discontinued. 


4.  The corporate tax rate in Argentina is 35%. 


Jackson is also considering the option of trying to make the South American operations profitable. She believes that with more emphasis on marketing and sales, EL could be successful. Details and assumptions made by Jackson for this option are as follows:

1.  To increase sales, an additional marketing specialist would be hired immediately at an annual cost of $110,000 including benefits. This is $20,000 higher than the next highest paid employee in EL's Argentina office. 


2.  The new marketing specialist should be able to acquire two new customers in each of the next two years and each customer will generate annual revenue of $100,000. One additional new customer will be acquired each year thereafter and each will generate annual revenue of $100,000. 


3.  Hiring a new marketing specialist will necessitate the purchase of office furniture with a total cost of $5,000. The CCA rate in Argentina for office furniture is 10%. Assume there is no CCA half- year rule in Argentina. 


4.  EL will not lose any existing customers over the next five years and will be able to retain all newly acquired customers over that same period. This contrasts with the typical churn rate for high-tech companies of about 20% per year. 


5.  Variable expenses will continue at the same rate as in the most recent fiscal period for the next five years. 


6.     The marketing specialist will receive a commission of 10% of revenue generated from new cus- tomer acquisitions. 


7.  Existing total fixed expenses of $310,000 per year, including the $40,000 allocation from head of- fice for computer support, will be unchanged for the next five years. 


Required:

1.    Should the South American operations be discontinued or should Jackson hire a new marketing 
specialist in an attempt to grow the business? Because of the uncertainty in the South American operating environment, Jackson wants you to preparee your analysis of the two options for a five- year period. EL has a required return of 12%. 


2.  Regardless of your recommendation for part 1, what qualitative factors should Jackson consider when deciding whether or not to discontinue operations in South America? 


3.  Assume that the marketing specialist will be able to acquire two new customers in the first year, but thereafter only one new customer will be acquired each year. Each new customer will generate an- nual revenue of $100,000. Given this new assumption, revise your analysis of the option to con- tinue operations in South America. Assume all other details and assumptions regarding this option remain unchanged. Should the operations be discontinued or should the new marketing specialist be hired? 


4.  What do the results of the revised analysis in part 3 above suggest about the riskiness of the option to hire a new marketing specialist? How could this risk be incorporated in your analysis? 


Answer 1

Year	1	2	3	4	5
Option 1 - shut down
non tax deductible expense/ non taxable incomes
Salvage	15,000
tax deductible expense/ taxable incomes
Severance	(50,000)
Fixed charge	(40,000)
Net tax deductible expense/ taxable incomes	(90,000)
Tax benefit	(31,500)
Net cost/ benefit of shutdown	46,500	0	0	0	0
Option 2 - marketing specialist
New acquisitions	200,000	200,000	100,000	100,000	100,000
Additional revenue (1)	200,000	400,000	500,000	600,000	700,000
Variable cost (45% of sales) (2)	(90,000)	(180,000)	(225,000)	(270,000)	(315,000)
Commission (3) (10% of new acquisition)	(20,000)	(40,000)	(50,000)	(60,000)	(70,000)
Contribution margin (4= 1-(2+3))	90,000	180,000	225,000	270,000	315,000
Contribution margin from existing sale (5)	220,000	220,000	220,000	220,000	220,000
Salary (6)	(110,000)	(110,000)	(110,000)	(110,000)	(110,000)
Additional cost (7)	(5,000)
Fixed cost (8)	(310,000)	(310,000)	(310,000)	(310,000)	(310,000)
EBIDTA (9= 4+5-(6+7+8))	(115,000)	(20,000)	25,000	70,000	115,000
Tax (10= 9*35%)	(40,250)	(7,000)	8,750	24,500	40,250
PAT (11= 9-10)	(74,750)	(13,000)	16,250	45,500	74,750
PV of PAT	(66,741)	(10,364)	11,566	28,916	42,415
NPV	5,793

Note- the PAT and the net cash flow to firm are the same since there is no additional capital investment, depreciation or interest expense. The tax in the years when there is a loss is added back to the EBIDTA as this is the tax benefit (credit) that can be used to reduce the overall tax liability of the firm at some other level.
1
The contribution margin in the existing case positive. The firm is not able to generate profits from the operations due to high fixed cost. Even if do not allocate the $40,000 fixed cost from head office, the operations are still loss making. This is an economic situation which has 2 different approaches in short term and long term. In short term, the firm is not able to be become profitable. Hence, it should shut down. In the long term, it should try to lower the overheads and expense to improve the profit margins. In the long term, if the firm could improve the profit margins, it could be become profitable. This can be seen from the second option where the firm decides to employ the marketing specialist. As the firm increases sales, the contribution margin improves and the business turns overall profitable from next year. Hence, it should employ the marketing specialist to improve the business. The NPV from the specialist is low but it can improve even further in the long run if the firm is able to scale up.

2
The considerations regarding increase in sales, contribution margin, profit margin and allocation of fixed costs are quantitative factors. In addition to these, the firm should consider following qualitative factors- market reach and diversification benefits that can be enjoyed from presence in different territory such as Argentina; opportunity for scaling and reaching other countries in South America; employee morale in other parts of the business; and possible economies of scale from additional business units. Benefits from some of these factors can not be calculated in dollar terms and should be considered as a part of strategic vision for the business rather than short term cash flow view.

3

Year	1	2	3	4	5
Option 2 - marketing specialist (low growth)
New acquisitions	200,000	100,000	100,000	100,000	100,000
Additional revenue (1)	200,000	300,000	400,000	500,000	600,000
Variable cost (45% of sales) (2)	(90,000)	(135,000)	(180,000)	(225,000)	(270,000)
Commission (3) (10% of new acquisition)	(20,000)	(30,000)	(40,000)	(50,000)	(60,000)
Contribution margin (4= 1-(2+3))	90,000	135,000	180,000	225,000	270,000
Contribution margin from existing sale (5)	220,000	220,000	220,000	220,000	220,000
Salary (6)	(110,000)	(110,000)	(110,000)	(110,000)	(110,000)
Additional cost (7)	(5,000)
Fixed cost (8)	(310,000)	(310,000)	(310,000)	(310,000)	(310,000)
EBIDTA (9= 4+5-(6+7+8))	(115,000)	(65,000)	(20,000)	25,000	70,000
Tax (10= 9*35%)	(40,250)	(22,750)	(7,000)	8,750	24,500
PAT (11= 9-10)	(74,750)	(42,250)	(13,000)	16,250	45,500
PV of PAT	(66,741)	(33,681)	(9,253)	10,327	25,818
NPV	(73,531)
EBIDTA without $40,000 from HO	(75,000)	(25,000)	20,000	65,000	110,000
Tax	(26,250)	(8,750)	7,000	22,750	38,500
PAT	(48,750)	(16,250)	13,000	42,250	71,500
PV of PAT	(43,527)	(12,954)	9,253	26,851	40,571
NPV	20,194

As can be seen from the calculation above, if the specialist can not acquire the 2nd client in the second year, the company has a -ve NPV over the 5-year period. However, the overall contribution margin from the business is still positive. Hence, the problem with the firm is of cost management. It has high fixed expense and will need more time and bigger scale to break even and make profit. This can be seen from the additional calculation at the bottom. If we do not allocate the fixed cost from HO, the NPV of the business is positive and there firm is profitable.

4
We concluded in the previous part that if the specialist is unable to acquire 1 additional client, the whole operation becomes unprofitable. This is the risk involved in the option. To quantify this risk, we can- 1) increase the discount rate (required ROR) for this option from 12% to a higher figure, say 15%; 2) calculate the probability of not meeting the targeted sales and incorporate the probability weighted NPV of this option; or 3) perform a scenario analysis and arrive at the most likely outcome and most likely NPV from the marketing specialist.