East Street PLC
East Street PLC is a medium sized corporate based in Aberdeen, Scotland. It manufactures and sells a range of guitars and musical instruments to both personal shoppers and online customers throughout Europe.
It is considering the manufacture of a new “quality, entry model” blues guitar – “Glory Days.” “Glory Days” is aimed at a market segment which the company has identified as being poorly served currently. It is anticipated the guitar will have an effective market life of 5 years.
To progress the manufacture and sale of the new guitar, the company estimates that an initial machinery and equipment investment of some £2,000,000 will be required. Current accounting policy is to depreciate such investments over five years in equal annual instalments.
Currently, East Street use their weighted average cost of capital uplifted by a further 2% “risk premium” to determine the discount rate for application in routine capital investment appraisal calculations. However some senior members of the management board of the company suggest that a rate of 15% is more appropriate in this case to take account of the additional risk element in entering, what is for the company, a new market segment.
As an alternative to “in-house” manufacture, East Street could out-source production to a group company, Clapton PLC. The senior managers are presently equally divided on whether to produce the new guitar in-house or to out-source.
The senior managers of East Street would like to know if it is profitable to progress the “Glory Days” as an entry level product and given the current financial environment, if significant additional cash flow and “shareholder value added” will be generated. They feel that a detailed analysis which took account of the 5 year timeframe of the product would be helpful.
Relevant financial data is set below:
1. Estimated sales volumes, selling price and costs (annual)
Annual Sales Volume 6,500 units
Unit Selling Price £250
Unit Variable Costs £125
Fixed Costs (excluding depreciation) £100,000
A number of senior managers in the company suggest that these estimates may be a little optimistic. They are anxious to have a financial evaluation for a “pessimistic” scenario and an assessment of how this might influence the decision to invest and enter the market. A pessimistic estimate of the market could be:
Annual Sales Volume 5,850 units
Unit Selling Price £225
2. Estimated Costs of Out-source contract to Clapton PLC
Clapton will sell “Glory Days” to East Street at a transfer price of £210 per unit. The contract will be for 6.500 units annually. Should actual demand be less than this level then East Street will still be required to purchase the contracted volume.
3. Capital Structure
East Street PLC is financed by a mix of equity and debt as follows:
Equity: 50%; ordinary shares with a historic dividend rate of 10%
Debt: 50%; long term, non-tradable loans with a post tax interest cost of 6%
Required
Using the information presented in the case and any other relevant research prepare a report for the senior managers of East Street PLC which addresses the proposed production of the “Glory Days”
Your report must include, but need not be limited to:
1. A recommendation on whether or not to enter the market with the “Glory Days”. Your recommendation should be supported with relevant calculations and analysis; these must include an assessment of profitability, break-even analysis and cash flow (undiscounted) over the 5 year product life.
2. A recommendation on the preferred basis of manufacture – either “in-house” or out-sourced to Clapton PLC. Your recommendation should be supported with relevant calculations and analysis; these must include net present value and a sensitivity analysis.
3. An evaluation of the theoretical basis of the financial techniques you have used, including how risk is taken into account.
4. An assessment of any wider business issues, both internal and external to the company which may impact the decision.
Guidance on Approach and Assessment
1. There is no “right” answer to this case study. The data allows for several assumptions and interpretations to be made; this is an attempt to duplicate the reality of management decision making where information is never complete. In marking the calculation elements credit will be given provided the approach adopted is reasonable and is justified. In assessing the report element, a logical flow of argument is expected, based on the supporting calculations and a synthesis of material to arrive at a sustainable recommendation.
2. It is essential that you document all assumptions underlying your analysis. Assumptions made must be realistic.
3. A critical awareness of the financial techniques used is required – their limitations and underlying assumptions.
4. Most data is based on estimates; how sensitive is your recommendation to the accuracy of these estimates – how much would they have to change for your recommendation to change?
5. Remember that investment decisions are not taken purely on the quantitative financial appraisal. Are there other qualitative factors which are important to identify in the report?
6. Ensure your conclusions and recommendations are justified and supported by the facts.
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