Question

Alfahome Plc is a company making a range of popular household liquid cleaning products. It has a loyal customer base as customers tend to use the same products for many years. Alfahome Plc’s target return on investment is 15% per annum. The company replaces assets regularly to keep them up to date.

The company regularly produces a 6 year plan. The plan for the six years is shown below:

Year	Net income ($M)	End of year Net Assets ($M)
2017	75	400
2018	80	400
2019	75	400
2020	65	400
2021	70	400
2022	40	400

Alfahome Plc has a range of products in regular demand and a few more fashionable products with life cycles. One of its products is expected to peak in 2019 and then begin to decline, so a new, fashionable product ‘Mega Wash’ with a potentially short life is being developed.

Although production of ‘Mega Wash’ will mostly use current available capacity, new machinery costing £72 million will be needed. This will be bought in at the beginning of 2019 and depreciated straight line over four years. The products are sold in cartons of 10 bottles.

In addition to the new machine, the table below shows the forecast cost and revenue cashflows (note 1) for Alfahome:

	2018	2019	2020	2021	2022
Research and Development (note 2) ($M)	6	4
Marketing ($M)	4	12	6	8	4
Fixed costs (note 3) ($M)		15	Note 3	Note 3	Note 3
Price per catron ($)		30	28	25	20
Variable production costs (note 3) ($)		6	Note 3	Note 3	Note 3
Variable marketing costs (note 3) ($)		2	Note 3	Note 3	Note 3
Examinated market demand (cartons) ($)		2000000	5000000	6000000	4500000

Notes

1. The cashflows shown in this table can also be regarded as accrual based costs and revenues for each year.

2. Research and development cost are written off in the year incurred.

3. It is expected that variable production, variable marketing, and product fixed costs will increase by 4% each year.

Price, marketing cost and market demand are the amounts estimated by the marketing department.

Required:

(a) Calculate the residual income of the company for each year of the forecast, before consideration of the new product.

(b) Calculate and present on a year by year basis, the ‘Mega Wash’ lifecycle and calculate the residual income of the ‘Mega Wash’ for each year of its life and the total residual income for the company as a whole for each year of the six year forecast.

(c) Calculate the Net Present Value of the ‘Mega Wash’ Lifecycle. Using 15% cost of capital:

Year	Discount factor at 15%
0	1
1	0,870
2	0,756
3	0,658
4	0,572

(d) Comment on the viability of proceeding with the ‘Mega Wash’ and its effect on the yearly residual income target.

(e) Discuss how the information provided by the calculations in parts a–c can be used in the future strategic decisions of the company.

Answer 1

1. Residual Income of the company for each year of the forecast, before
consideration of the new product
Residual income = Net income -(Average assets x minimum required rate of return)
Minimum required rate of return =15%
Average Assets = $400m as it is same over the period of 6 years
Year	Net Income ($M)	Average Assets ($M)	ROI	Return on Assets	Residual Income (NI -ROA)
2017	75	400	15%	60	15
2018	80	400	15%	60	20
2019	75	400	15%	60	15
2020	65	400	15%	60	5
2021	70	400	15%	60	10
2022	40	400	15%	60	-20
NI = Net Income
ROA = Return on Assets

2. "Mega Wash" lifecycle and residual income
	2018	2019	2020	2021	2022
Price per carton ($)		30	28	25	20
Estimated Market Demand (Cartons)		2000000	5000000	6000000	4500000
Variable Production costs per carton ($)		6	6.24	6.49	6.75
Variable Marketing Costs per carton ($)		2	2.08	2.16	2.25
Sales Revenue		60000000	140000000	150000000	90000000
Variable Production costs ($)		12000000	31200000	38937600	30371328
Variable Marketing Costs ($)		4000000	10400000	12979200	10123776
Contribution Margin		44000000	98400000	98083200	49504896
Less:
Fixed Cost		15000000	15600000	16224000	16872960
Marketing	4000000	12000000	6000000	8000000	4000000
Research and Development costs	6000000	4000000
Net Profit	(10,000,000)	13,000,000	76,800,000	73,859,200	28,631,936
Assets at the beginning		72000000	54000000	36000000	18000000
Assets at the end		54000000	36000000	18000000	0
Average Assets		63000000	45000000	27000000	9000000
ROI	15%	15%	15%	15%	15%
Return on assets	0	9450000	6750000	4050000	1350000
Residual Income	(10,000,000)	3,550,000	70,050,000	69,809,200	27,281,936
Total Residual income for the company as a whole for each year of six year forecast
Year	Residual Income       (NI -ROA)($M)	Residual Income for Mega Wash ($M)	Residual income for the company as a whole
2017	15		15
2018	20	-10	10
2019	15	3.5	18.5
2020	5	70	75
2021	10	70	80
2022	-20	27	7

3. Net Present value of the "Mega wash" Lifecycle
	2018	2019	2020	2021	2022
Machinery Cost		(72,000,000)
Net Profit	(10,000,000)	13,000,000	76,800,000	73,859,200	28,631,936
PV Factor	1	0.87	0.756	0.658	0.572
Net Present Value	(10,000,000)	(51,330,000)	58,060,800	48,599,354	16,377,467
NPV Total					61,707,621
Cost of machinery is cash outflow in 2019
4. The project of "Mega Wash" with a short life of 4 years is viable as its NPV is positive and it will
increase the residual income for the company as a whole. In 2022 as per the six year forecast, residual income
will be negative but if they will start this project, residual income will be positive.
5. In future strategic decisions, company can use the information about the residual income forecast
for the next six years, and also it can compare new product with Mega wash net income, residual value
and net present value.