In: Accounting
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.
1. Residual Income of the company for each year of the forecast, before |
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consideration of the new product |
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Residual income = Net income -(Average assets x minimum required rate of return) |
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Minimum required rate of return =15% |
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Average Assets = $400m as it is same over the period of 6 years |
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Year |
Net Income ($M) |
Average Assets ($M) |
ROI |
Return on Assets |
Residual Income (NI -ROA) |
2017 |
75 |
400 |
15% |
60 |
15 |
2018 |
80 |
400 |
15% |
60 |
20 |
2019 |
75 |
400 |
15% |
60 |
15 |
2020 |
65 |
400 |
15% |
60 |
5 |
2021 |
70 |
400 |
15% |
60 |
10 |
2022 |
40 |
400 |
15% |
60 |
-20 |
NI = Net Income |
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ROA = Return on Assets |
2. "Mega Wash" lifecycle and residual income |
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2018 |
2019 |
2020 |
2021 |
2022 |
|
Price per carton ($) |
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: |
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Fixed Cost |
15000000 |
15600000 |
16224000 |
16872960 |
|
Marketing |
4000000 |
12000000 |
6000000 |
8000000 |
4000000 |
Research and Development costs |
6000000 |
4000000 |
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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 |
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Year |
Residual Income (NI -ROA)($M) |
Residual Income for Mega Wash ($M) |
Residual income for the company as a whole |
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2017 |
15 |
15 |
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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 |
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2018 |
2019 |
2020 |
2021 |
2022 |
||
Machinery Cost |
(72,000,000) |
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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 |
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Cost of machinery is cash outflow in 2019 |
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4. The project of "Mega Wash" with a short life of 4 years is viable as its NPV is positive and it will |
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increase the residual income for the company as a whole. In 2022 as per the six year forecast, residual income |
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will be negative but if they will start this project, residual income will be positive. |
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5. In future strategic decisions, company can use the information about the residual income forecast |
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for the next six years, and also it can compare new product with Mega wash net income, residual value |
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and net present value. |