Case 10:The Lazy Mower: Is It Really Worth It? Case Discussion
Objectives • Estimate cash flows resulting from a new project. • Use scenario and sensitivity analyses in evaluating capital budgeting proposals. • Measure cash, accounting, and financial break-even of a new project. • Discuss contingency planning issues.
Background Information • The design team at Creative Products Company (CPC) had unveiled a fully-tested, proto-type of their latest innovation, the remote-controlled” lawn mower, nick-named the “The Lazy Mower. • Before being given the “go ahead” to go into full-scale production of the Lazy Mower, the team had to present a detailed feasibility study to the Capital Investment Committee, which was chaired by the Vice President of Finance, Gary Lester. • The proposal had to include detailed cost and revenue estimates with sufficient documentation to substantiate the numbers.
Question 1: • Prepare a Pro Forma Statement showing the annual cash flows resulting from the Lazy Mower project.
Answer 1 See spreadsheet for solution Please note that the sales are expected to vary in the range of 20,000 – 28,000 units.
Question 2: • Use a scenario analysis to show how the cash flows would change if the sales forecasts were 15% worse (Pessimistic) and 15% better (Optimistic) than the stated forecast (base).
Answer 2 • See spreadsheet for cash flows relative to scenarios(Spreadsheet link)
Question 3 • Realizing that the CIC will demand some kind of sensitivity analyses, how should Dave and Rick prepare their report? • Which variables or inputs are obvious ones that need to be analyzed using multiple values? • Explain by performing suitable calculations.
Answer 3 • The variables that are vulnerable to economic and market factors such as competition, inflation, and recession are selling price per unit and variable cost per unit. • To some extent fixed cost can be sensitive as well. • Price per unit has been adjusted over the years to allow for downward trends due to competitive pressure. • However, cost sensitivity needs to be analyzed. • Variable cost per unit can be increased by 10% upto 30% and the impact on cash flows and Net Present Value and IRR can be analyzed. See spreadsheet for cash flows relative to sensitivity analysis(Spreadsheet link)
Question 4 • How should the interest expenses be treated? • Explain.
Answer 4 The interest expense should not be deducted when calculating the annual cash flows. Interest is a financing expense and is included in the discount rate used to calculate the NPV. If we deduct interest expenses we will be double counting.
Question 5: Using the base case estimates calculate the cash, accounting, and financial breakeven of the Lazy Mower project. Interpret each one.
Answer 5 • Price per unit = $700 (upto 72,000 units) • Variable cost per unit = $400 • Annual Fixed Operating Cost = $2,120,000 (includes opportunity cost of rent) • Depreciation = 3,000,000 (assuming straight line depreciation)
Answer 5 (Continued) Accounting Break-Even = (Fixed Cost + Depreciation)/(Price – Variable Cost) = $5,120,000/($700-$300) = 17,067 units This indicates that net income will be zero at a sales level of 17,067 lazy mowers. Any sales above that point will result in profit for the year. Since the sales forecasts are considerably higher than this level the project seems acceptable. However, the cost of capital is not accounted for by the accounting break-even.
Answer 5 (Continued) Cash Break-Even = Fixed Cost/(Price-Variable Cost) = $2,120,000/$300 = 7,067 units Without including depreciation costs, the firm would need to sell only 7,067 mowers to break even i.e. to cover its fixed operating costs. At this point the operating cash flow would be zero. Cash-break even does not account for the cost of the project nor the cost of capital.
Answer 5 (Continued) Financial Break-Even = (FC + Operating Cash Flow*)/(Price – Variable Cost) Where Operating Cash Flow* = level of Cash flow that results in a zero NPV PV = -30,284,126; n=10; FV = 0; i/y = 18%; CPT PMT = $6,738,661.42 Financial Break-Even = ($2,120,000+$6,738,661.42)/$300 = 29,529 units The financial break-even is the most comprehensive and conservative of the three break-even measures. It calculates the sales level that has to be reached to get an NPV of zero. The firm would have to sell 29,529 units a year to get there. Under the base case scenario, this sales level is higher than the annual forecasts for the 10 years, making the project a risky venture.
Question 6 • Let’s say that the company had spent $500,000 in developing the prototype of the Lazy Mower. • How should Dave and Rick treat this item in their report? • Please explain.
Answer 6 • This is a sunk cost and should not be included in the analysis. • The money was spent prior to making the decision whether or not to accept the project.
Question 7: • Calculate the IRR of the project. • Based on your calculations what would you recommend? Why?
Answer 7 Spreadsheet solution (click here) Under the base case scenario, the IRR of the project is 25%. Since the weighted average cost of capital is 18%, the project is acceptable. The estimated cash flows indicate that the project will provide a rate of return that far exceeds the hurdle rate. Even under the worst case scenario, the IRR if 22% exceeds the cost of capital.
Question 8 How sensitive is the Net Present Value of the project to the cost of capital?
Answer 8 Click here for graph (NPV Profile)
Question 9 • Calculate the operating leverage entailed by this project. • What does it indicate?
Answer 9 • Degree of Operating Leverage = 1 + (Fixed Cost/Operating Cash Flow) • Where Operating Cash Flow = -FC+(P-VC)*Q • So at 20,000 units, • OCF = -3120,000+(300)20,000 = 2,880,000 • DOL = 1+3120000/2880000=2.083 The DOL indicates that a 10% increase in the output of lazy mowers will increase the operating cash flow by 20.83% and vice-versa, The greater the DOL the more vulnerable the project will be to errors in forecasting.
Question 10 • What other types of contingency planning should Dave and Rick include to make the report comprehensive? • Please explain the relevance of each suggestion.
Answer 10 • Dave and Rick should plan for the following types of contingencies: The option to expand. What if the ‘lazy mower’ concept really takes off? Can production be increased without too much additional expenditure? Planning early can avoid later unnecessary costs. What about the effect on price? Can costs be reduced through economies of scale? The option to abandon. Some discussion or planning must be included regarding what can be done in case the project does not break even on a cash flow basis. Could the operations be scaled back or abandoned and some of the investment recouped? The option to suspend or contract operations . If there is excess inventory can operations be temporarily suspended or permanently scaled back and costs minimized?