DuraBike Case Study Sample

• Subject Name : Financial Management

Financial Management

Executive Summary of Financial Management

The analysis in the report has been conducted for providing an explanation in relation to all the relevant issues to the proposed marketing strategy and investment in the machinery. The analysis is conducted on behalf of the Chief Financial Officer (CFO) of the Company. The CFO is interested in reviewing the details of the new marketing strategy with liberal credit policy using cash cycles and working capital management, an evaluation of the purchase of new machineries using capital budgeting methods and the sources of financing have been conducted in this analysis. The primary aim of the analysis and report writing is to give clear reasons (both quantitative and qualitative) to the CFO of DuraBikes to help him to make better investment decision. The analysis has used all the required financial tools that can be used in the proposal appraisal.

Table of contents

Executive summary.

1 Introduction.

1.1 Operating Cycle and Cash Conversion Cycle.

1.1.1 Cash Conversion Cycle.

1.1.2 Operating Cycle (OPC).

2 Working Capital Management.

2.1 Break Even Point (BEP) Analysis.

2.1.1 Calculation.

2.1.2 Analysis.

3 Appraisal of Liberal Credit Policy.

4 Weighted Average Cost of Capital (WACC).

4.1 Calculation.

4.2 Analysis.

5 Capital Budgeting.

5.1 Payback Period.

5.2 Net Present Value (NPV).

5.3 Internal Rate of Return (IRR).

6 Benefits of the NPV..

6.1 Net Present Value vs. Payback Period.

6.2 Net Present Value vs. IRR.

7 Divestment for raising funds.

7.1 Calculation of Fair Value.

7.2 Final Decision.

8 Decision Making and Recommendations.

References.

Introduction to DuraBike

DuraBike is a New York, USA based company that is engaged in the business of manufacturing bikes. The economic and financial activities all around the world have been greatly impacted by the COVID-19 pandemic and DuraBikes is not an exception. The company has been suggested to launch an aggressive 10-year marketing campaign. The campaign proposes a more liberal credit policy which is going to extensively increase the annual sales of bikes. To satisfy the increased demand in result of the campaign, DuraBike is required to purchase new machines.

The chief financial officer (CFO) is provided with all the relavant and material information required to conduct an analysis to forecast the possible outcomes of the marketing campaign. It is the responsibility of the CFO to assess and identify whether the investment in new machineries are warranted and what how the company is going to finance or fund the proposed investments in new machineries.

For such assessment, the capital budgeting methodologies can be utilized which includes techniques like Net present value (NPV), Internal rates of return (IRR), Payback period (PBP), etc.

Capital budgeting is a quantitative process that allows a business to choose the best possible alternative investment with similar risk. It is an important process of business operations that forecast future and make improved decisions.

1.1 Operating Cycle and Cash Conversion Cycle

Operating and cash cycles are tools to determine the effectiveness of a business in managing its cash flow. Company’s investment in inventory, results in cask blocks until such inventory is sold out and all the cash has been collected. That means, the company might suffer with liquidity problems as no cash available for other uses. Therefore, it is always recommended for businesses to maintain a short cash conversion and operating cycles. A short cycle will result in maximum liquidity and minimum storage costs.

1.1.1 Cash Conversion Cycle

The cash conversion cycle (CCC) is a financial quantitative tool that determines the time (in days) a business takes to convert its investments in inventory into cash through sales and includes the available cash due to deferrals in payments to supplier. The CFO at Durabike is analysing the results of increasing the cash collection period from 30 days to 60 days.

1.1.1.1 Calculation

CCC=DIO+DSO−DPO

Where:

• DIO = Days of inventory outstanding
• DPO = Days payables outstanding
• DSO = Days sales outstanding

1.1.1.2 Analysis

CCC of Durabikes is negative (-5 days), when DSO is 30 days. It indicates that the company is selling all of its products in cash, but don’t pay the sellers immediately. Such credit policy is not viable for a manufacturer. When the DSO is increased to 60 days keeping all other factors same, the CCC rises to 25 days, less than a month, an acceptable figure. The following scenario analysis can help the CFO in better decision making

Table1: CCC Scenario Analysis

1.1.2 Operating Cycle (OPC)

The time that a business requires to convert raw materials into cash through sales is its operating cycle. It does not consider the deferrals in payments to suppliers.

1.1.2.1 Calculation

OPC =DIO + DSO

1.1.2.2 Analysis

The OPC of Durabikes with 30 days of DSO remains 55 days which rise to 85 days if DSO increases to 60 days. The steep rise in OPC is due to high DIO, the company is required to decrease these figures while increasing DSO as it is taking nearly a month (25 days) in selling its outstanding inventory.

Table2: Operating Cycle Scenario Analysis

Working Capital Management

Working capital management ensures that the company efficiently operating by utilizing its current liabilities and assets to the best effect. Its main purpose is maintenance of sufficient cash flow to pay company’s short-term debt obligations and operating costs.

Considering the company sell 100 bikes per day, the working capital requirement is $ 4472, if the cash is collected within 30 days. It is obvious that working capital financing needs to be increased, if the cash collection period is increased from 30 days to 60 days. For 60 days period, the increased financing for working capital will be $5167 and total requirements will be $9639. The calculations are shown in appendix 2.

Table3: Working Capital Financing

2.1 Break Even Point (BEP) Analysis

BEP analysis calculates the margin of safety (MOS) by determining the units that are required to be sold to cover both variable and fixed costs. It equates total revenues with total expenses and determines when a project will become profitable.

2.1.1 Calculation

2.1.2 Analysis

The estimated annual sales of Durabikes is 21900 bikes, since the BEP as per calculations (shown in appendix 3) is just 17500 bikes, a much lower figure, therefore, the company will not only be able to achieve the corresponding cash and accounting break-even points but also will be able to generate a substantial amount of profits with the sales of additional 4400 bikes.

Appraisal of Liberal Credit Policy

Based on the calculations and analysis made for the aggressive marketing strategy that includes increment of cash collection period from 30 days to 60 days, the proposal of marketing department can be accepted. The following brief explanations will justify the acceptance of the project:-

• The CCC was negative 5 days at DSO of 30 days; such figures can be considered good for a software company with zero inventories or an ecommerce company. The CCC rises to 25 days when DSO increased to 60 days. However this figure is required to be compared with industry average, but a CCC of less than a month for a manufacturer is acceptable.
• The working capital requirements increased from approx $4500 to $9500, which is an increment of $ 5000. However this calculation is made for an average per day sale of 100 bikes, which means 36500 bikes per year. Although, the estimated sales remains 21900 bikes, therefore, if company is able to manage the incremental working capital requirements for 100 bikes per day, then it can easily manage the WC requirements for 21900 bikes per year.
• The break even analysis provides a clear picture that the proposal is beneficial for the company as BEP will be achieved at 17500 bikes, therefore, with estimation of selling 21900 bikes per year, the company will make profits.

Weighted Average Cost of Capital (WACC)

WACC is the overall cost of capital of a company in which costs of various sources of capital are proportionately weighted including common stock, debt securities, etc.

4.1 Calculation

Where:

• TMV = Equity + Debt (values) = Total Market Value of the firm
• Ke = cost of equity
• Kd = cost of debt

The cost of debt for Durabike’s business is provided, to determine the cost of equity, CAPM method can be implemented:

Where

• Rf = Risk free rate
• Rm = Market rate of return
• β = beta

4.2 Analysis

Given the cost of debt of the company is 8%, and the cost of equity as per CAPM comes out to be 10.9%. The company’s capital structure includes two primary components including debt and equity in the ratio of 20:80 (20% and 80% respectively). Therefore, the WACC of the company becomes 9.84%.

Capital Budgeting

Capital budgeting is a quantitative process that allows a business to choose the best possible alternative investment with similar risk. It is an important process of business operations that forecast future and make improved decisions. It includes techniques like Net present value (NPV), internal rates of return (IRR), Payback period (PBP), etc.

5.1 Payback Period

Payback period is a popular traditional method that determines the time to recover the initial capital investment of an investment. In other words, PBP is that period when the project reaches its breakeven point. A proposal that has shorter period is considered to be attractive.

The Payback period for the investments in new machineries is 6.19 years while the company has a payback cut-off period of 7 years. Since the investment takes lesser time in the recovery or to reach BEP as compared to cut off period, therefore, the proposal must be accepted.

5.2 Net Present Value (NPV)

NPV is a modern tool that uses discounted cash flows and incorporates the effects of time value of money. The project can be accepted if the NPV is positive or at least equal to zero. But if it becomes negative, the proposal needs to be rejected.

The NPV assessment will use DuraBike's weighted average cost of capital (9.84% as calculated) as the discount rate.

The NPV for the investments in new machineries comes out to be -$ 2817. An investment with negative NPV should not be accepted.

5.3 Internal Rate of Return (IRR)

IRR is a discount rate which makes NPV of a proposal equal to zero. If IRR exceeds the proposed or required rate of return, then the proposed project can be accepted and vice versa.

The IRR of the project is 9.836%, while the required rate of return (company’s WACC) is 9.840%. Since, IRR is lower than WACC; hence the proposal cannot be accepted.

Therefore, it can be concluded that the proposal of purchasing new machineries will eventually result in losses to the company as per capital budgeting analysis. Hence the project must not be accepted.

Benefits of the NPV

Net Present Value is considered to be the best measure for investment appraisal as compared to other methods including payback period (PBP) and Internal Rate of Return (IRR) due to the following reasons:-

6.1 Net Present Value vs. Payback Period

There are two major drawbacks with the technique of PBP, which are:

1. It does not take the cash flows after the PBP into account.
2. The method of PBP totally ignores the time value of money (TVM).

NPV considers the TVM and also considers all the cash flows occur till the useful life of the project ends.

6.2 Net Present Value vs. IRR

The major drawbacks with the technique of IRR are:

1. IRR is percentage and ignores the dollar value of the project, also remains unable to understand the economies of scale. Differentiation between two projects of same IRR is difficult. While NPV provides absolute values, and are comparable.
2. IRR assumes cash flow’s reinvestment and discounting at the same rate. For example, IRR of a good project can be 30%, but it will be impossible to make market investments at this rate. Whereas, NPV considers a rate of lending as well as borrowing close to the market rates, therefore remain practical.
3. When there is more than one negative net cash flow, then the project can have multiple IRR instead of one, hence, the equation is solved with two values. Such a problem does not exist with NPV.

Divestment for Raising Funds

In order to finance the marketing proposal and purchase of new machineries, the CFO at DuraBikes is planning to liquidate some of the company’s investments due to tightened borrowing requirements. The company has made investments in (or owns) two types of securities including:

1. Treasury bonds with face value of $1,000, annual coupons of $50, yield to maturity of 4% per annum, periods to maturity of 10 years and
2. Ordinary shares of XYZ Company with current dividend per share of $0.50, dividend growth rate of 5% per annum and required rate of return (RRR or Ke) of 10%.

The CFO is likely to liquidate either of these two investments to raise necessary funds. In the current scenario of COVID-19 pandemic, most financially viable and healthy securities have lost some values, therefore, right now a more profitable investment will be sold and the other will be kept invested till it make recoveries.

To make the decision of liquidation, it is required to determine the fair present values of both of these two investments (the calculations are shown in appendix). The security which has a market rate higher than the fair present value (as per calculations) will be considered to be profit generating investment and will be liquidated to raise funds.

7.1 Calculation of Fair Value

Treasury Bonds: The bond valuation method will be utilized in which the present value of all the future cash flows will be calculated to determine the fair value of the bond (Treasury Bond in this case)

The present value of expected cash flows is added to the present value of the face value of the bond as seen in the following formula:

Where:

• C = coupon payments
• YTM = yield to maturity (discount rate)
• FV = face value of the bond
• t=number of periods
• T=time to maturity

The calculated fair value of the Treasury bond is $ 1081.11 per unit, while the market price is currently at $1100 per unit. That means the bond is overvalued, and arises an opportunity to go short or sell the bonds in the market.

Ordinary Shares: The dividend discount model (DDM) will be used, according to which, stock’s current fair price (ordinary shares of XYZ Company in this case) should be the sum of all the future dividends, discounted back to their present value.

Where:

• V0 = current fair (intrinsic) value of a stock
• D1 = D0 + g, next period’s dividend from now
• Ke = Cost of equity
• g = growth rate

The intrinsic value of XYZ stocks comes out to be $ 10.5 per share, while the market rates per share are $ 10. That means the XYZ stocks are trading at lower rates than its fair price, hence are undervalued and indicates towards opportunity of buying.

7.2 Final Decision

Stocks are undervalued and its market prices of $ 10 will tend to move towards the fair value of $10.5, since more profitability is estimated for stocks in future, hence it will be retained in the company and the bonds will sold (due to exact opposite reason) to raise the funds.

Limitations and Recommendations on Financial Management

Based on the calculations and analysis conducted by the CFO of the company suggests that it will in the benefit of the company to implement the proposal of the marketing department. However there are some areas related to procurement of machineries which needs to be altered because its NPV is close to zero, but negative also there is a very small difference between WACC and IRR. The company can reduce its overall cost of capital by altering the capital structure of the company and adding a little more debt capital while proportionately reducing the equity capital. An addition of as little as 10% into the debt portion can make the NPV figure positive and reduce the WACC to become lower than the IRR (as shown in appendix).

References for Financial Management

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Malenko, A. 2019. Optimal dynamic capital budgeting. The Review of Economic Studies, 86(4), 1747-1778.

Pinkasovitch, A. 2019. 'An introduction to capital budgeting', Investopedia, Jun 25, viewed 6 October 2019, https://www.investopedia.com/articles/financial-theory/11/corporateproject-valuation-methods.asp.

Roy, D., Rudra, D. and Prasad, P. 2017. Capital Structure and Capital Budgeting: An Empirical and Analytical Study of the Relationship. Research Bulletin, 42(4), pp.50-60.

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