Ben Guslists, vice-president of sales, has recommended adding a new product line. A market study and cost analysis show that the new line should yield the following annual results:
New Sales $2,800,000.00
Cost of Sales $1,600,000.00
Operating Expenses $200,000.00
Total Expenses $1,800,000.00
Income before Income taxes $1,000,000.00
Income taxes (40%) $400,000.00
Net Income $600,000.00
Depreciation of $150,000.00 is included in total expenses. Cost of sales and operating expenses include only direct costs of the new line.
Financial data for last year, considered to be a typical year, are:
Net Sales $12,000,000.00
Cost of Sales $7,500,000.00
Operating Expenses $1,800,000.00
Total Expenses $9,300,000.00
Operating Income $2,700,000.00
Interest Expense $100,000.00
Income before Income taxes $2,600,000.00
Income taxes (40%) $1,040,000.00
Net Income $1,560,000.00
Total Assets $12,000,000.00
Current Liabilities $3,000,000.00
Long term debt $1,000,000.00
Shareholders’ equity $8,000,000.00
Total liabilities and equities $12,000,000.00
Depreciation expense included totals $400,000.00 for the firm.
The investment in additional equipment for the production and sale of the new product line has been estimated at $3,000,000.00. “The new product line will yield a 20 percent return on assets,” Guslists states.
Steve Grunewald, the vice-president of production, interrupts, “Are you talking about a cash-flow return, Ben?” he asks. “No,” Guslists answers. “When depreciation is added back, the cash-flow return will be greater.”
The vice-president of finance, Jude Gallagher, asks, “How do you think we should finance the investment?”
“We should be able to issue long term notes”, Guslits responds. “Our debt at the present time is modest. And with debt financing, we gain the advantage of leverage.”
“In your estimate, Ben you forgot to include any interest cost. It will cost us $150,000.00 after income taxes to finance $3,000,000.00,” Gallagher replies.
Required:
1.What impacts will the new product line have on profit measures and cash flows?
2.Examine and comment on Guslits’ strategy to finance the investment. Is it likely that shareholders will be impressed with the investment? Why?
3.In your opinion, is the investment attractive? Explain.
ANSWERS (for checking)
1. Implementation of the new product line will yield a total product of $2,010,000 unlike profit last year with only $1,560,000.00. In addition, cash inflows after implementation will be $2,340,000.00 compared to last year with only $1,800,000.00
2. Guslits used debt financing to finance the new product line of the company, it means that he chose to issue long term payable incurring interest cost rather than issuing share of stocks or equity financing. It is noted that the company's debt to equity ratio last year was only 50% however with the new product line, the company's debt to equity will be increased to 87.5% making them highly leveraged and exposing them to a possible default in a worst case scenario. But in this scenario, the possible gain outweights the cost of paying the interest. Overall, the new investment is impressive because both the overall profit and cash inflows increased by $450,000 and $540,000 respectively.
3. Yes, the investment is attractive because it will have a positive impact when it comes to profit and cash flows however, the company will have a negative net cost of investment amounting to $810,000 but in the opinion, it is common since it is only in the first year of operation. In addition to this, the payback period is only 5.833 years; this means that it will only take 5 years and 10 months to recover their investment and the remaining 14 years and 2 months will produce net profit for the company (life of investment is 20 years)
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1. The new product line will have a positive impact on profit measures and cash flows. The net income is projected to increase to $600,000 from $1,560,000, while the cash inflow is expected to increase to $2,340,000 from $1,800,000. This indicates a significant improvement in both profit and cash flow.
2. Guslits' strategy to finance the investment through debt financing may not be well-received by shareholders. While leveraging can be advantageous, it also increases the risk of default in case of financial difficulties. Furthermore, the interest cost of $150,000 after taxes will reduce the overall profitability of the investment. Shareholders may be concerned about the increased leverage and the potential impact on the company's financial stability.
3. Overall, the investment appears to be attractive. The increase in net income and cash inflows indicates that the new product line will add value to the company. Although there will be a negative net cost of the investment in the first year ($810,000), it is a common occurrence and expected in the initial phase of a project. The payback period of 5.833 years suggests that the company will be able to recover its investment relatively quickly and generate net profit for the remaining duration of the investment.
1. The impact of the new product line on profit measures and cash flows is as follows:
- Profit measures: The new product line is expected to generate an additional net income of $600,000.00. This will increase the company's income before income taxes by $1,000,000.00 and net income by $600,000.00 compared to last year's figures. The new product line will contribute positively to the company's profitability.
- Cash flows: The implementation of the new product line will result in an increase in cash inflows. The cash inflow after implementation is expected to be $2,340,000.00, which is an increase of $540,000.00 compared to last year's cash inflows of $1,800,000.00. The new product line will lead to higher cash flows for the company.
2. Guslists' strategy to finance the investment is to issue long-term notes and incur interest costs. He believes that the company's current debt level is modest, and leveraging debt financing will provide advantages. However, Jude Gallagher points out that the interest cost of $150,000.00 will be incurred after income taxes to finance the $3,000,000.00 investment.
With debt financing, the company will have a higher debt-to-equity ratio. Although it may impress shareholders initially due to the increased profitability and cash flows expected from the new product line, the high leverage may also increase the risk for the company. Shareholders will need to evaluate the potential benefits and risks associated with this financing strategy.
3. The investment in the new product line appears to be attractive. The profit measures, such as income before income taxes and net income, are expected to increase by $1,000,000.00 and $600,000.00, respectively. The cash inflow after implementation is expected to be $2,340,000.00, an increase of $540,000.00 compared to the previous year.
Although the investment will result in a negative net cost of $810,000.00 initially, this is common for new investments in the first year. The investment is projected to have a payback period of 5.833 years, meaning that it will take approximately 5 years and 10 months to recover the initial investment cost. The remaining 14 years and 2 months of the investment's life will generate net profit for the company.
Overall, considering the increase in profit measures, positive cash flows, and relatively short payback period, the investment in the new product line appears to be attractive.
To answer these questions, we will analyze the provided financial data and make calculations based on the numbers given.
1. Impact on Profit Measures and Cash Flows:
To analyze the impact of the new product line on profit measures and cash flows, we compare the financial data for last year (considered a typical year) with the projected financial results for the new product line.
Profit Measures:
- Net Income: Last year's net income was $1,560,000.00, while the projected net income for the new product line is $600,000.00. This indicates a decrease in net income due to the expenses associated with the new product line.
- Income before Income taxes: Last year's income before taxes was $2,600,000.00, while the projected income before taxes for the new product line is $1,000,000.00. This also indicates a decrease in income before taxes.
Cash Flows:
- Cash Inflows: Last year's cash inflows were $1,800,000.00, while the projected cash inflows for the new product line are $2,340,000.00. This indicates an increase in cash inflows due to the new sales generated by the product line.
- Cash Flow Return: Ben Guslists mentioned that the new product line will yield a 20% return on assets. This means that after adding back the depreciation expense, the cash flow return will be greater. However, the specific cash flow return percentage is not provided.
Based on these comparisons, the new product line results in a decrease in net income and income before taxes but an increase in cash inflows.
2. Strategy to Finance the Investment:
Ben Guslits suggests financing the investment in the new product line through long-term notes, taking advantage of debt financing and leverage. Debt financing allows the company to borrow funds and benefit from the leverage effect. However, Jude Gallagher points out that interest costs of $150,000 will be incurred after income taxes to finance the $3,000,000 investment.
Considering the additional interest cost, the debt financing strategy may lead to increased financial burden and reduce the overall profitability of the investment. Shareholders may have mixed reactions to this strategy. On one hand, debt financing allows the company to retain ownership and control, and the potential returns from the new product line may outweigh the interest costs. On the other hand, the increased debt burden and risk associated with leverage may concern shareholders, especially if the company's debt to equity ratio becomes too high.
3. Attractiveness of the Investment:
Overall, the investment in the new product line is attractive based on the provided data. While there is a decrease in net income and income before taxes in the first year due to the expenses associated with the new line, the investment has several positive aspects:
- Increase in Net Sales: The new product line is projected to generate $2,800,000.00 in new sales, contributing to overall revenue growth.
- Increase in Cash Inflows: The cash inflows after implementation are expected to be $2,340,000.00, indicating a positive impact on the company's cash flow.
- Return on Assets: Ben Guslists claims that the new product line will yield a 20% return on assets. While the specific calculation is not provided, a positive return on assets suggests profitability.
- Payback Period: The investment is recoverable within 5.833 years (rounded to 5 years and 10 months), meaning that the initial investment can be recouped within a reasonable timeframe.
Considering these factors, it can be concluded that the investment in the new product line is attractive and shows potential for generating increased profits and positive cash flows in the long run.
Please note that the answers provided are based on the given information and assumptions made. It is recommended to perform a detailed financial analysis and consider other factors before making any investment decisions.