Background: Case Study
Due to its strong financial performance, Hillside Industries – a public listed company – is considering the expansion of its operations by pursuing a plant extension. As a background, Hillside’s revenues have substantially increased based on demand growth for its products, currently at levels not seen since 2010. Working as the company’s Chief Financial Officer, you have been asked to assess the aforementioned plant extension plan and presenting (in a report) your recommendations to the Board of Directors (BoD).
The current figures at Hillside indicate that the company has sold 12,500 units in the last financial year, with projected sales of 15,000 units over the next five years (annually). Since relying on more efficient fully automated machines (the initial investment for which is discussed below), the new plant will have the capacity to produce 20,000 units/year. To cover the gap between forecasted sales and the capacity of the new plant, the marketing department has suggested to launch an aggressive campaign (amounting to a cash expense of $40,000/year) whereby the payment period to wholesale customers is extended from 15 to 30 days – this will presumably lead to the additional demand of 5,000 units/year required to cover the gap.
The projections above assume a sale price of $100 per unit, and that Hillside would be liable to pay its suppliers 12 days from the date of purchase of raw materials, with the cost of raw materials being $30/unit. Also relevant is the fact that it currently takes 15 days for the company to convert raw materials into finished goods, with production levels of 60 units/day.
The investment envisaged by the production manager of Hillside to carry on with the business expansion entails the installation of a newly developed, fully automated production technology in the new plant. The details associated with this investment are as follows:
Forcasted Future Free Cash Flows (Years)
Initial Investment 1 2 3 4 5
$270 000 $47 000 $61 000 $95 000 $97 000 $150 000
1. Based on the previous behaviour of the company’s stock, the beta of Hillside’s shares is Moreover, the current economic scenario is such that the risk-free interest rate is 1% per year, with financial analysts expecting a rate of return of 6% on the market portfolio (i.e., the relevant index representing the stock market). Hillside has also previously issue corporate debt that will mature in 15 years ($1,000 face value, 4% annual coupon rate) currently priced at $896. Finally, the company’s liabilities amount to 60% of its balance sheet and assume the tax-shield in Australia as 30%.
Key questions to be addressed
1. Based on the background provided in the case study, you are to write a report addressing the following key questions:
In terms of working capital requirements, what are the implications of increasing the payment period (or average collection period) from 15 to 30 days? Please refer to the operating and cash conversion cycles in your answer.
2. Based on the forecasted sales, is it possible for Hillside to achieve the corresponding cash and accounting break-even points? Based on your calculations for each – and from a pure cost management perspective – is the marketing department’s proposal acceptable? Explain.
3. Use the net present value (NPV) criteria to assess whether the expansion plan is warranted (Hint: use Hillside’s weighted average cost of capital as its discount rate and the CAPM to calculate the cost of equity). Explain to the BoD the benefits of the NPV vis-a-vis other capital budgeting methodologies.
4. Based on the cost of equity and the cost of debt, which of the two sources (bonds or shares) should the company use to raise the funds for the expansion plan? Explain the reasons behind your decision.
5. Based on the answers to the previous questions, determine whether to endorse the recommended plan to the Board.