Question

In: Accounting

Alfahome Plc is a company making a range of popular household liquid cleaning products. It has...

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.

Solutions

Expert Solution

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.


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