What are the different methods of pricing that one could consider in formulating a pricing strategy, which of these would be most helpful in the car market and what additional information might be helpful for you in setting this strategy? (5 marks) 2 Following are the last year data related to the company’s cheap video screen production unit: (to fit inside the car)
Because of the Brexit risk, company’s newly appointed investment manager Ms Helen comes up with a new investment strategy – closing five of company’s existing brand and focusing more on the company’s most popular brand in the UK. According to her assessment, this closing decision will generate around £100 million free cash flow, which the company could reinvest to expand its popular brand – ‘@X Drive’. Helen suggests that the market survey indicates this is one of the most popular brands in England, and demand is increasing. The year-to-year sales of this brand have gone up by 10% (5,000 units in 2019), which was higher than all those five brands together.
Moreover, she has indicated that the expansion decision will reduce the overall cost while improving quality. This cost-quality dynamic will further help the company to face competition and to achieve a larger market share. However, this expansion will cost £150 million for the company, which require rigorous strategic assessment, including financial viability. Now, she has approached you to evaluate this possible restructuring decision, whether it is a financially viable strategy or not. She also has suggested that this expansion project will run for the next five years, and after that, the company will enter into a new strategic cycle.
You have collected the following information from her to do the financial analysis for meaningful decisions.
It is expected that the expansion will increase the sales of ‘@Xdrive’ by the following units.
8,000 units in 2020
8,000 units in 2021
10,000 units in 2022
11,000 units in 2023
12,000 units in 2024
In 2019 the market price of this brand was £35,000, but the company wants to reduce it by £5000 in 2020 and then will increase/decrease with the pace of the economy and purchasing power of the consumers. KPMG has projected that the Bank of England’s bank rate will remain 0.25 per cent for the next couple of years, which will allow the post-Brexit expansion of the economy. In line with this economic assessment, your company has decided not to increase the price for next three years, but in the fourth and fifth year, a contingency plan is in place to increase the unit price by £1000.
The production cost is £15000 per unit, which will increase in the line of inflation and other materials cost over the life of the project at a rate of 5% each year starting from year two. The production involves fixed overhead expenditure of £20 million in 2020 and 2021, £15 million in 2022 and £10 million in 2023 and 2024. There is an estimation of working capital investment of £850,000 at the starting of this project, 50 per cent of which the company will recover at the end of project life. The cost of promotion and R&D will be £5 million each over the life of the project. Assume, there is no other cost involved in these projects. The company is currently following the straight-line depreciation method, and historically 10% of the cost price of such investment is recovered in the final year.
Financing choices: (the Board of Directors have agreed)
The Board of Directors did not agree to reinvest the £100 million free cash flow from closing the existing five brands. Instead, they want to keep this fund as a reserve for future uncertainty. For this expansion project recommended by Ms Helen, the Board has recommended raising capital from alternatives financing suing external sources.
The company has three choices for financing this expansion – issuing new equity or issuing a bond or issuing preference shares.
The equity of Angle PLC is currently trading in the London Stock Exchange (LSE) with a face value of £10. The market price of each share is as follows:
|To date||£ 34.80|
The company had declared £1.2 per share dividend (DPS) in the last fiscal year. Company’s investment banker KPMG always charges an issuing (i.e. flotation) cost of 20% on the face value to issue new common stock in the market. Historically, the company’s earnings per share are as follows:
|Year||EPS (Earning Per Share|
The company has also assessed the possibility of issuing a bond in the market. Currently, bonds of similar companies are selling at £105, slightly over the face value (i.e. £100) with a coupon rate of 10% and maturity of 5 years. Company’s third financing option is to issue preferred stock in LSE. The industry average preferred dividend and the current market price of preference shares of similar companies are £10 and £98, respectively.
For analysis, you also have collected some additional data related to the UK financial market and the company. Currently, the yield of 3-month Treasury bills is 3.0%, the FTSE 100 index has an average yearly return of 10%, and the average corporate tax rate in the UK is 30%. The beta of Angle PLC is 1.5, which is slightly higher than the market beta of 1.
The company wants to maintain its existing capital structure policy of 50% debt, 10% preferred equity and 40% of common equity for this new investment.
Ms Helen has requested you to make a report based on the following queries so that she can present it in the next board meeting.
- What will be the cost for each source of financing? Consider both DDM (i.e. Dividend Discount Model) and CAPM (i.e. Capital Asset Pricing Model) method for common equity. Provide your comments on the assumptions of each approach and their merits and limitations. (5 marks)
- Determine the optimum cost of capital using the Weighted Average Cost of Capital (WACC) approach for target capital structure. (Hints: Ms Helen would prefer to use CAPM over DDM). (5 marks)
- Evaluate the total value addition (i.e. total NPV) and breakeven rate (i.e. IRR) of this possible restructuring decision. (Hints: Use the WACC as your discount rate to evaluate the investment projects) (10 marks)
- Assume that the product lifecycle of five years is viewed as a safe bet, but the scale of demand for the product is highly uncertain, mainly due to possible BREXIT. Analyse the sensitivity of the projected NPV to the unit sales and the cost of capital. (5 marks)
- Explain how the BREXIT could affect the UK automobile manufacturing sector, and what are the possible strategic changes required in this industry to cope with the risk? (5 marks)
[Following profit statement is just for your reference to calculate the net cash benefit given by your investment manager Ms Helen]
|Cost of Sales||(908)||(1,056)||(1,855)||(1,897)||(1,754)|
|Gross Profit (Loss)||714||744||875||757||949|
|Stock Upkeep Cost||0||1||0||17||31|
|Research and Development||0||194||20||27||16|
|Operating Profit (Loss)||461||238||448||323||267|
|Investment Disposal Income||0||8||11||0||0|
|Interest on Current Account||0||7||8||8||10|
|Interest on Loans||(34)||(45)||(33)||(11)||(12)|
|Pre-Tax Profit (Loss)||427||208||434||320||265|
|Post Tax Profit (Loss)||342||181||308||183||187|
|Cost of Dividends||(20)||(40)||(36)||(40)||(28)|
|Year Retained Profit (Loss)||322||141||272||143||159|
The management team also come up with some questions and request you to explain/answer them for the upcoming board meeting:
- What are the different methods of pricing that one could consider in formulating a pricing strategy, which of these would be most helpful in the car market and what additional information might be helpful for you in setting this strategy? (5 marks)
- Following are the last year data related to the company’s cheap video screen production unit: (to fit inside the car)
The Angle PLC had made sales of 46,000 units at £80 each and produced 50,000 units.
|Variable costs per unit:||£||Fixed costs for the year:||£|
|Production overhead – incurred
Production overhead – estimated
The company absorbs fixed production overhead based on the annual budgeted volume of cost units, which were 40,000 for the year just ended. The company also has got 5,000 units as beginning stock at £55 and 4000 units of the screen as closing stocks.
The team wants you to prepare the income statement under both absorption and marginal costing methods. They also want to know the possible reasons for any difference in net income in two statements and reconcile any such difference.
- What are the rationales for preparing zero-based budgeting? Is it feasible for this company? – explain? (Marks 5)
- The company now wants to expand their video screen production unit to smart screen production, which is now a very competitive market, as a customer could play any video from online or from their other smart device without a wired connection.
This unit is currently employed about 200 people in its factory on the outskirts of Leeds.
Data relating to this product are shown below:
|Direct material cost/unit
Budgeted direct labour hours/unit
Direct labour rate/hour
Variable overhead/direct labour hour
Budgeted sales/production volume
Plant and machinery associated with this new product are expected to depreciate at £100,000 per annum. The company uses the straight line method to depreciate fixed assets.
The company uses a full costing approach to calculate product cost. Corporate fixed overhead is apportioned based on the number of direct labour hours used. Currently, corporate overhead is £300,000, and total direct labour hours are 40,000.
The company wishes to establish a margin for the product such that it achieves a 20% margin on selling price.
The team is suggesting you prepare a report on the market feasibility of this product and also to determine the possible selling price for their new product.
(Marks: 5 + 5 = 10)
Thank you and best of luck