08 Jun evaluation of a proposed capital expenditure for equipment that would expand the firm’s manufacturing capacity. Using the traditional NPV methodology, she found the project unacceptable because NPV traditional = -$1,700 < $0 Before recommending rejection of the proposed project, she has decided to assess whether there might be real options embedded in the firm's cash flows. Her evaluation uncovered three options: Option 1; Abandonment; The project could be abandoned at the end of 3 years, resulting in an addition to NPV of $1,200. Option 2; Expansion; If the project outcomes occurred, an opportunity to expand the firm's product offerings further would become available at the end of 4 years. Exercise of this option is estimated to add $ 3,000 to the projects NPV. Option 3: Delay; Certain phases of the proposed project could be delayed if market and competitive conditions caused the firm's forecast revenues to develop more slowly than planned. Such a delay in implementation at that point has a NPV of $10,000. Jenny estimated that there was a 25% chance that the abandonment option would need to be exercised, a 30% chance that the expansion option would be exercises, and only a 10% chance that the implementation of certain phases of the project would have to be delayed. a) use the information provided to calculate the strategic NPV, NPV strategic , for Asor Products' proposed equipment expenditure. b) judging on the basis of the findings in part a, what action should jenny recommend to management with regard to the proposed equipment expenditure? c) In general, how does this problem demonstrate the importance of considering real options when making capital budgeting decisions?
In January 2012, Teresa Leal was named treasurer of Casa de Diseno. She decided that she could best orient herself by systematically examining each area of the company’s financial operations. She began by studying the firm’s short-term financial activities.Casa de Diseno is located in Southern California and specializes in a furniture line called “Ligne Moderna.” Of high quality and contemporary design, the furniture appeals to the customer who wants something unique for his or her home or apartment. Most Ligne Miderna furniture is built by special order because a wide variety of upholstery, accent trimming, and colors is available. The product line is distributed through exclusive dealership arrangements with well-established retail stores. Casa de Diseno’s manufacturing process virtually eliminates the use of wood. Plastic and metal provide the basic framework, and wood is used only for decorative purposes.
Casa de Diseno entered the plastic-furniture market in late 2004. The company markets its plastic-furniture products as indoor-outdoor items under the brand name “Futuro.” Futuro plastic furniture emphasizes comfort, durability, and practicality and is distributed through wholesalers. The Futuro line has been very successful, accounting for nearly 40 percent of the firm’s sales and profits in 2011. Casa de Diseno anticipates some additions to the Futuro line and also some limited change of direction in its promotion in an effort to expand the applications of the plastic furniture.
Leal has decided to study the firm’s cash management practices. To determine the effects of these practices, she must first determine the current operating and cash conversion cycles. In her investigations, she found that Casa de Diseno purchases all of its raw materials and production supplies on open account. The company is operating at production levels that preclude volume discounts. Most suppliers do not offer cash discounts, and Casa de Diseno usually receives credit terms of net 30. An analysis of Casa de Diseno’s accounts payable showed that its average payment period is 30 days. Leal consulted industry data and found that the industry average payment period was 39 days. Investigation of six California furniture manufacturers revealed that their average payment period was also 39- days.
Next, Leal studied the production cycle and inventory policies. Casa de Diseno tries not to hold any more inventory than necessary in either raw materials or finished goods. The average inventory age was 110 days. Leal determined that the industry standard, as reported in a survey done by Furniture Age, the trade association journal, was 83 days.
Casa de Diseno sells to all of its customers on a net-60 basis, in line with the industry trend to grant such credit terms on specialty furniture. Leal discovered, by aging the accounts receivable, that the average collection period for the firm was 75 days. Investigation of the trade association’s and California manufacturers’ averages showed that the same collection period existed where net-60 credit terms were given. Where cash discounts were offered, the collection period was significantly shortened. Leal believed that if Casa de Diseno were to offer credit terms of 3/10 net 60, the average collection period could be reduced by 40 percent.
Casa de Diseno was spending an estimated $26,500,000 per year on operating-cycle investments. Leal considered this expenditure level to be the minimum she could expect the firm to disburse during 2012. Her concern was whether the firm’s cash management was as efficient as it could be. She knew that the company paid 15 percent annual interest for its resource investment. For this reason, she was concerned about the financing cost resulting from any inefficiencies in the management of Casa de Diseno’s cash conversion cycle. (Note: Assume a 365-day year and that the operating –cycle investment per dollar of payables, inventory, and receivables is the same.)
To Do
A. Assuming a constant rate for purchases, production, and sale throughout the year, what are Casa de Diseno’s existing operating cycle (OC), cash conversion cycle(CCC), and resource investment need?
B. If Leal can optimize Casa de Diseno’s operating cycle (OC), cash conversion cycle (CCC), and resource investment need to be under these more efficient condition?
C. In terms of resource investment requirements, what is the cost of Casa de Diseno’s Operational inefficiency?
D. (1) If in addition to achieving industry standards for payables and inventory, the firm can reduce the average collection period by offering credit terms of 3/10 net 60, what additional savings in resource investment costs will result from the shortened cash conversion cycle, assuming that the level of sales remains constant?
(2) If the firm’s sales (all on credit) are $40,000,000 and 45% of the customers are expected to take the cash discount, by how much will the firm’s annual revenues be reduced as a result of the discount?
(3) If the firm’s variables cost of the $40,000,000 in sales is 80%, determine the reduction in the average investment in accounts receivable and the annual savings that will result from this reduced investment, assuming that sales remain constant.
(4) If the firm’s bad-debts expenses decline from 2% to 1.5% of sales, what annual savings will result, assuming that sales remain constant?
(5) Use your findings in parts (2) through (4) to assess whether offering the cash discount can be justified financially. Explain why or why not.
E. On the basis of your analysis in parts a through d, what recommendations would you offer Teresa Leal?
F. Review for Teresa Leal the key sources of short-term financing, an account payable, that she may consider for financing Casa de Diseno’s resource investment need calculated in part b. Be sure to mention both unsecured and secured sources.
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