What is the current cash conversion cycle of the company? What does it tell?. [ad_1]
Case Study – BIA
BIA is a medium-sized firm that operates in Australia. The company has grown rapidly over the past couple of years. Its growth slowed down recently, so the firm is planning a rebranding project to sustain its expansion. As the finance manager, you will have to evaluate the financial viability of the rebranding project and provide relevant suggestions where possible.
Various departments of the firm have done intensive research and suggest launching a 10-year rebranding project. This project will involve a fixed cash cost of $3,200,000 per year for rent, insurance, marketing and other purposes. Under the same project, the payment period to wholesale customers will be relieved from 10 to 30 days, together with other rebranding strategies, leading to an increase in annual sales estimated as follows (three possible scenarios):
- Pessimistic: 60,000 units per year
- Neutral: 75,000 units per year
- Optimistic: 90,000 units per year
While BIA is selling its product at an average price of $100/unit, the average variable cost is $45/unit (including material, utility bill and labour cost for production). The company is liable to pay its supplier in 30 days on average. Manufacturing and selling the product take a total of 20 days on average. To accommodate the expected increase in sales due to the project, BIA would need to buy a new automated production line costing $3,800,000 today, with a lifetime of 10 years (assume straight-line depreciation and ‘zero’ salvage value).
As per the above estimates (e.g., sales increase, relevant revenue and costs) and assume they remain the same every year, your finance analyst estimated that this project generate a fixed amount of annual cash flow for 10 years as follows:
- Pessimistic: $184,000
- Neutral: $761,500
- Optimistic: $1,339,000
To assess the viability of this project, you have decided to utilize the capital budgeting techniques you learned in your MBA study. For this purpose, the finance analyst recommended a 10% required rate of return based on the weighted average cost of capital (WACC) of the firm. Moreover, the company has an increasing debt ratio in the past five years as below:
Key Questions To Address
Based on the case study above, you are to write a report addressing the following key questions:
- What is the current cash conversion cycle of the company? What does it tell?
What are the impacts on the operating cycle and cash conversion cycle due to the increase in the payment period (i.e., average collection period) from 10 to 30 days?
Also, assuming the company is currently selling 411 units of clothing per day, by how much should the firm increase or reduce its working capital financing to accommodate this change in the average collection period?
- Based on the forecasted sales, is it possible for BIA to achieve the corresponding cash and accounting break-even points each year under each scenario (pessimistic, neutral, and optimistic)?
Based on your calculations for each – and from a pure cost management perspective – is the marketing department’s proposal acceptable? Why or why not?
- Discuss why NPV is considered the best capital budgeting criteria.
Use the Payback period and Net-Present Value (NPV) to assess whether the project is viable under three different scenarios. When evaluating the payback period, consider a payback cut-off of 5 years. Is this project viable based on NPV and payback period?
- Considering the level of risk and uncertainty involved in this project, you feel that the required rate of return of 10% might be a bit low to account for the risk. Experiment with a higher required rate of return and recalculate NPV (e.g., 15%, 20%). What do you find?
- Comment on the capital structure of the firm and its trend over time, and then answer the question: Should the firm issue new shares or issue bonds to finance the new project?
- Based on the answers to the previous questions, determine whether to endorse the rebranding project to the board of directors.
- Finally, reflect on the limitations of the analyses.