Financial Feasibility of the Business †Click to get a Free Solution

Question: Discuss about the Financial Feasibility of the Business. Answer: Introduction Mrs. Fanny who lives in Chicago has recently taken retirement and has received a sum of $475000 for 30 years of work with the pharmaceutical company. She has decided to start a new venture with the amount in hand. Mrs. Fanny wants to sell gourmet chocolates imported from France in the US markets. She will be purchasing the gourmet chocolates from Choc-O-LaySA an established company in France which is known for its fine chocolates with unusual and innovative flavors. Choc-O-LaySA will provide Mrs. Fanny exclusive rights to sell their products in USA. Mrs. Fanny will have to provide an upfront payment for the exclusive rights and the rights will be for 5 years. Her husband has decided to support her with her new business idea and has suggested to develop a financial plan for the feasibility of the business. Mrs. Fanny has conducted a market study in the USA to understand the demand of the gourmet chocolate and the price people will be willing to pay for the gourmet chocolate from France. The market survey by Mrs. Fanny revealed that the demand for the gourmet chocolate will be 750kg a month. But initially the demand will be only 75kg and gradually grow to its full potential and Mrs. Fanny will be able to sell 750kg a month by the end of the first year. The cost of the market study was $6500. Also it was found that the demand for the gourmet chocolate was price elastic i.e. the demand for the gourmet chocolate could be double if Mrs. Fanny reduced the price by 10%. Mrs. Fanny has decide to sell the gourmet chocolate directly to the customers via internet only and for this purpose has got in touch with a website developer who can make a website for her at $3500. She will require a refrigerator which will cost her $5250. The other expenses which Mrs. Fanny will have to incur are the packag ing and shipping cost of the gourmet chocolate to the customers which is at $2 per kg, credit card interest cost by the credit card company at 1% of the sales, rent of the office from where Mrs. Fanny will operate is $420 with a 3 month deposit to be paid and the cost of the employee who will help Mrs. Fanny with the business which will cost her $2650 per month. Apart from the internet sales, Mrs. Fanny will also be able to sell her gourmet chocolate t her friend Mrs. Mitch. Mrs. Mitch runs a small chain of delicatessens in Chicago. She is interested in Mrs. Fannys venture and has promised to purchase gourmet chocolate from her. However, she wants her to pack the gourmet chocolate in tin boxes with each tin box containing 550g of chocolates. She said if Mrs. Fanny could provide the same she will be purchasing 100 such boxes per month. The cost of purchasing such tin boxes is $1.75 per box and selling price would be $62. The assistant who can help Mrs. Fanny with processing such boxes will charge $750 per month. Mrs. Fanny will have to pay tax at 30% of the total profit generated every year. She can also request a loan of $50000 at 8% p.a. Mrs. Fanny wants to understand the financial implications of her business so that she can decide whether she should go ahead with this business or not. Breakeven Analysis Breakeven Analysis is a method to find the revenue a business must generate such that the total revenue is equal to the total cost of the business. i.e. at Breakeven point there is no profit and loss. It is given by Break even analysis = (Gallo, 2014) Cost of import of gourmet chocolates = 68.875 / kg = $76.45 [ 1 = $1.11] Transportation cost from France to USA = 18/ kg = $19.98 Shipping cost = $2/ kg Revenue = $120/ kg Credit Card cost = 1% of revenue = $12 Unit margin = 120 76.45 19.98 2 - 12 = $9.57 Refrigerator cost = $5250 Market study cost = $6500 Website design cost = $3500 Salary cost = $ 31800 Rent = $5040 Fixed costs = $5250 + 6500 +3500 + 40800 + 5040 = 61090 Thus breakeven point = 61090/ 9.57 = 5443.05 kg Thus Mrs. Fanny should sell more than 5443.05 kg of gourmet chocolate to earn profit. If the number of chocolates sold through internet is less than 5443kg then she will not be able to cover the fixed cost of $61090 she will incur. The net income of each month is given below. The company will be able to breakeven in 12 months. Month 0 1 2 3 4 5 6 7 8 9 10 11 12 Net income -24312 -11456 -3644 -2566 -1420 -275 871 2017 3163 4308 5454 6600 87458 Cumulative -24312 -35768 -39412 -41979 -43399 -43674 -42803 -40786 -37623 -33315 -27861 -21261 66197 Profit and loss statement ITEMS ITEM BREAKUP FIRST YR. Operating Revenue Sale from Internet 627750.00 Other Revenue Sales to Mitch 74400.00 Total Revenue 702150.00 Cost of Goods sold chocolate imported from France 557013.80 Operating Expenses Salary Assistant and Employee 40800.00 Rent 5040.00 Market Study 6500.00 Credit card 1% of the revenue 7021.50 Shipping cost Due to sales on internet 10462.50 Depreciation Assuming Straight line for 5 years 1050.00 EBIT Revenue minus expenses 74262.00 Net Interest Expense No loan taken 0.00 PreTax Profit revenue minus operating and interest expenses 74262 Tax Expense 30%on earned income 22278.66 Net Profit after Tax total revenue minus tax expenses 51983.54 The Profit and loss statement is a financial statement which helps in summarizing the revenues, expenses and recording profit for a specific period (usually a year). This statement is useful for the investors and owners to understand the revenues generated by the company and if the business is able to generate profits for the shareholders. (Investopedia) The Profit and loss statement can be divided into Operating revenue, Other revenue, Operating expenses, EBIT and Profit. Operating revenue The Operating revenue of the company is the revenue generated by the company from daily sales. Thus it is the main source of income of the business. In this case, the sale of gourmet chocolate to the customers via internet is the primary source of revenue and hence the operating revenue. The company was able to sell 5231.25 kg via internet at $120 per kg and hence the operating revenue = $627750. Other revenue The Other revenue of the company is the revenue generated by the company from sources other than daily sales. Thus it is secondary source of income of the business. In this case, the sale of gourmet chocolate to Mrs. Keith was the secondary source of income of the business and hence the other revenue. The company was able to sell 1200 units to Mrs. Keith at $62 per box. Hence the other revenue = $74400. Thus the total revenue of the company = 627750 + 74400 = $702150. Operating expense: The Operating expense of the company is the expense incurred by the company to complete it sales. In this case, the Operating expenses include cost of import goods sold, rent of office, salary to the employees, credit card cost, market study cost, depreciation and shipping cost. Thus total operating expense = 557013.80 + 5040 + 40800 + 7021.50 + 6500 + 1050 + 10462.50 = 627887.80 Assuming the life of the refrigerator to be 5 year and applying straight line depreciation on the refrigerator we get depreciation = 5250/ 5 = 1050. EBIT: EBIT is earnings before interest and taxes. It is the earning of the company by reducing all the expenses from the revenue earned by the company to get the earnings of the company before it pays interest on loan (if any) and taxes . For the business EBIT is calculate by subtracting the operating expense from the operating revenue. Thus EBIT = 702150 557013.80 = $74262.20 Interest expense It is the amount of money to be paid by the business as interest over the loan taken by the company. This amount is deducted from the EBIT before tax is implemented on the earnings as no tax is implemented on the interest. Mrs. Fanny has not taken any loan for the business. Hence the interest expense = 0 Net Profit The Net Profit of the company is the amount of profit generated by the company by doing business after paying taxes and can be given to the investors in the form of dividend or reused in the business in form of retained earnings. Net Profit = Profit Before Tax taxes = 74262.20 22278.66 = $51983.54. Taxes = 30% of 74262.20 = 0.3* 74262.20 = 22278.66 Conclusion Thus from the Profit and loss statement of the given business it can be said that the business will be able to generate profit in the first year and it will be equal to $51983.54. The revenue generated from sales was 702150 and the operating expenses were 627887.80. The net profit generated by the business is quite high and Mrs. Fanny will be able to easily expand her business and pay royalty to Choc. The overall financial health of the company looks good from the Profit and loss statement. Thus Mrs. Fanny should go ahead with this venture as the business will be able to generate profits in a year. Balance Sheet The Balance Sheet of a company is the financial statement which summarizes the total assets, liabilities and equity of the company at a given point in time. The Balance Sheet has three important parts: Assets, Liabilities and Shareholders Equity For any Balance Sheet, Assets = Liabilities + Shareholders Equity. (Averkamp, 2015) The following is the balance sheet for Mrs. Fanny ITEMS ITEMS Breakup FIRST YR CA Cash Generated from sales 68597.45 CA Receivables credit sales to customers 96200.00 CA Rent Deposit three month deposit 1260.00 CA Inventories Chocolate and tin inventory 76703.26 Total Current Assets 242760.70 NCA Equipment Refrigerator 5250.00 Accumulated Depreciation Life = 5 years and straight line 1050.00 NCA Investments website 3500.00 Total NCA 7700.00 Total Assets CA+NCA 250460.71 CL - Account Payable suppliers, wages, yearly rent 159688.51 Total Curr. Liabilities 159688.51 Total NCL 0 Total Liabilities 159688.50 Equity 38788.66 Retained Earnings 519683.54 Total Equity 90772.20 The balance sheet can be broken into Assets which consist of Current Assets and Non Current Assets, Liabilities which consist of Current Liabilities and Non Current Liabilities and equity which has shareholders equity and retained earnings. CA or Currents Assets The Currents Assets includes all the cash and cash equivalent of the company which can be easily converted to cash. Eg Cash, securities, advance payment, accounts receivables, inventory, etc. In this case Current assets of the company = $242760.71. NCA or Non Currents Assets The Non Currents Assets of the company are assets which take longer to convert to cash (more than one year). Eg Equipment, Investment in Website etc. In this case Non Current assets of the company = $7700. Thus the total assets of the company = 242760.71 + 7700 = 250460.71. CL or Currents Liabilities The Currents Liabilities are all the liabilities the company needs to pay to its account holders in a short span of time (less than one year). Eg Salary, rent, accounts payable, etc. In this case Current Liabilities of the company = $159688.51. NCL or Non Currents Liabilities The Non Currents Liabilities of the company are liabilities which the company needs to pay back in a longer period of time (more than one year).. In this case Non Current assets of the company = $0. Thus the total liabilities of the company = 159688.51 + 0 = 159688.51. Shareholders Equity: The Shareholders Equity consists of two parts: equity and retained earnings. Equity is the amount invested by the owners in the company to run the business. Retained earnings is the amount generated by the business as profit and which is reinvested in the business to help the business grow rather than sharing it with the shareholders. In this case Equity = 38788.66 and retained earnings = 51983.54. Thus Shareholders Equity = 38788.66 + 51983.54 = 90772.20 Cash Flow Statement The cash Flow Statement of a company tells in detail about the cash transactions of the company and helps in determining the cash present with the firm at any given point in time. In a business, the cash is used for operating activities (day to day operations of the business), investing activities (investment in long term assets like plant, property, machinery, etc.) and financing activities (purchase of shares, securities etc.) Cash Flow statement Month 1 Operating Activities Total revenue 0.00 Cogs 7232.44 Net income -7232.44 Rent -420.00 Credit card 0.00 Salary -3400.00 Cash used in operating activities -11052.44 Investment Activities Refrigerator -5250.00 Website design -3500.00 Rent advance Deposit -1260.00 Prepaid tax -22278.66 Market Study -6500.00 Cash used in investing activities -38788.66 Financing activities Equity 38788.66 The operating activities of the 1st month are: Revenue, Cost of goods sold, rent, salary, credit card cost. In the 1st month, the amount of gourmet chocolate sold will be received in the next month by the credit card company. Thus Revenue = 0. The Cost of goods sold is the amount paid for the purchase of the gourmet chocolate and shipping them to USA. COGS = $7232.44 Rent for the month = $420 Salary to the employees = 2650 + 750 = $3400 Since No revenue received this month, the cost of credit card = 0 Thus total cash flow in the operating activities = - (7232.44 + 420 + 3400 + 0) = - 11052.44 The amount is spent hence the cash flow is negative. The investment activities in the first month are purchase of Refrigerator, website design, market study, rent advance deposit and prepaid tax. Cost of refrigerator = 5250 Website design = 3500 Market study = 6500 Rent advance = 1260 Prepaid tax = 22278.66 Thus total cash flow in the investing activities = - (5250 + 3500 + 6500 +1260 + 22278.66) = - $38788.66 The financing activities in the first month is the amount invested by the Mrs. Fanny which is = $38788.66. Conclusion: The net cash flow value in the 1st month is negative. i.e. the cash outflow is more than the cash inflows. The revenue for this month will be realized in the next month so the income is zero but the expenditure for the month takes place hence net operating cash flow is negative. In the investment activities the cash outflow takes place due to purchase of assets and hence net investing cash flow is negative. In the financing activities, the cash inflow takes place due to investment from the equity. Annual Cash Flow Statement Cash Flow statement Year 1 Operating Activities Total revenue 702150.00 Cogs -504455.98 Net income 197694.02 Rent -5040.00 Credit card -7021.50 Salary -40800.00 Shipping cost -10462.50 Cash used in operating activities 134370.02 Investment Activities Refrigerator -5250.00 Website design -3500.00 Deposit -1260.00 Prepaid tax -22278.66 Market Study -6500.00 Cash used in investing activities -38788.66 Financing activities Equity 38788.66 Net cash 51983.54 The annual cash flow statement tells about the cash that goes in and out of the business. It helps in understanding where the cash was used and which the sources of revenue were for the company. The investors are interested in cash flow statement as it helps in determining whether the business will help them make profits and helps in understanding the viability of the business. In this case the net cash from the operating, investing and the financing activities is positive i.e. by doing the business the company will be generating more cash. Conclusion: The net cash flow is positive i.e. the company is able to generate cash by doing the business. Thus Mrs. Fanny should invest in the business as the business is profitable at the end of the first year. Discounted Cash Flow Analysis The discounted cash flow method is used for the valuation of the project by taking time value of money into consideration. In Discounted Cash Flow Analysis, the cash flow all the future years of the project is estimated and the these cash flows are discounted to their present value using the discount rate. If the sum of the discounted cash flow is less than the initial investment by the company, the company should not go ahead with the project but if the sum of the discounted cash flow is more than the initial investment by the company then the company should take the project as it will be profitable for the company. (Stockopedia, 2012) PV = present value = FV/ (1+r)n Where r is the discount rate and n is the number of years before the cash flow occurs, FV = future value of the cash flow. In this case, assuming straight line depreciation of the refrigerator with salvage value = 0 and life = 5 year, depreciation is calculated. Depreciation = (5250 - 0)/ 5 = 1050 Thus the Income statement for the next 5 years, assuming Mrs. Fanny is able to sell 750kg of gourmet chocolate each month is given below. Income Statement 5 years Year 1 2 3 4 5 kg of chocolates sold 5231.25 9000.00 9000.00 9000.00 9000.00 Sales 627750.00 1080000.00 1080000.00 1080000.00 1080000.00 Revenue from sales to Mitch 74400.00 74400.00 74400.00 74400.00 74400.00 Total revenue 702150.00 1154400.00 1154400.00 1154400.00 1154400.00 Expenses Rent 5040.00 5040.00 5040.00 5040.00 5040.00 Import of chocolate 504455.98 867881.25 867881.25 867881.25 867881.25 Shipping cost 10462.50 18000.00 18000.00 18000.00 18000.00 Credit card 7021.50 11544.00 11544.00 11544.00 11544.00 Employee salary 40800.00 40800.00 40800.00 40800.00 40800.00 Cost due to sales to Mitch 52557.83 52557.83 52557.83 52557.83 52557.83 Market Study 6500.00 0.00 0.00 0.00 0.00 Depreciation 1050 1050 1050 1050 1050 Total Expenditure 627887.80 996873.08 996873.08 996873.08 996873.08 Profit before Tax 74262.20 157526.93 157526.93 157526.93 157526.93 Tax 22278.66 47258.08 47258.08 47258.08 47258.08 PAT 51983.54 110268.85 110268.85 110268.85 110268.85 The discount rate is given as 4%. Hence calculating the DCF for the 5 years we get Discount rate @4% 1 2 3 4 5 Discounted cash flow 37131.10 56259.62 40185.44 28703.89 20502.78 Initial investment = 38788.66 Thus the net value of the project = -38788.66 + 37131.10 + 56259.62 + 40185.44 + 28703.89 + 20502.78 = $166272.82 Conclusion: Thus the net value of the project has been calculated and was found to be 166272.82. Thus by taking up the project Mrs. Fanny will earn $166272.82. Also the royalty she needs to pay to Choc-O-LaySA should be less than 166272.82 if she wants to earn a profit from the business. Sensitivity Analysis Sensitivity Analysis helps in finding how the change in an input value will affect the other dependent variables while the other assumptions are kept constant. (Investopedia, 2015). In this case the decrease in selling price by 10% will increase the demand by 2 times. Thus the company will be able to sell 150kg in the 1st month and the year-end monthly demand will increase to 1500 kg. Thus the new monthly cash flow statement will Month 0 1 2 3 4 5 6 7 8 9 10 11 12 kg of chocolate sold 150 375 487.5 600 712.5 825 937.5 1050 1162.5 1275 1387.5 1500 Sales 16200 40500 52650 64800 76950 89100 101250 113400 125550 137700 149850 162000 Revenue from sales to Keith 6200 6200 6200 6200 6200 6200 6200 6200 6200 6200 6200 6200 Total revenue 22400 46700 58850 71000 83150 95300 107450 119600 131750 143900 156050 168200 Expenses Initial Investment 16510 Rent 420 420 420 420 420 420 420 420 420 420 420 420 Import of chocolate 14465 36162 47010 57859 68707 79556 90404 101253 112101 122950 133798 144647 Shipping cost 300 750 975 1200 1425 1650 1875 2100 2325 2550 2775 3000 Credit card 224 467 588.5 710 831.5 953 1074.5 1196 1317.5 1439 1560.5 1682 Employee salary 3400 3400 3400 3400 3400 3400 3400 3400 3400 3400 3400 3400 Cost due to sales to Mitch 4380 4380 4380 4380 4380 4380 4380 4380 4380 4380 4380 4380 Total Expenditure 31275 45336 56652 67847 79042 90237 101432 112627 123822 135017 146212 157407 9882 Tax Prepaid 16957 Cash Flow each month -48231 -45336 -34252 -21147 -20192 -19237 -18282 -17327 -16372 -15417 -14462 -13507 146168 Thus it can be seen that the company will be able to recover the initial investment in 12 months and the profits will be much more than the profits earned at the current selling price. Hence the company should reduce the price. Conclusion Thus from the financial analysis I think Mrs. Fanny should go ahead with the venture as the business can breakeven in a year and generate profits for her and think that she should reduce her price by 10% so that profits are increased. Recommendations The following recommendations which I think can help Mrs. Fanny to run the business in a better way 1. In my view, the company should hedge the currency so that the fluctuations in dollar euro conversion rate will not affect the business 2. I would suggest Mrs. Fanny to choose suitable method of depreciation of assets to reduce the tax burden on the company. 3. I would recommend Mrs. Fanny to buy rights from Choc-O-LaySA at a price less than to earn profits in the business. 4. I think the company can reduce the shipping cost and bring efficiency in the distribution process to save on the spending. 5. In my view, investment in advertisement can help to increase the demand for the gourmet chocolate and hence the profitability of the business be increased. References Gallo,A. (2014). A Quick Guide to Breakeven Analysis. Retrieved on August 5, 2016 from https://hbr.org/2014/07/a-quick-guide-to-breakeven-analysis Averkamp, H. (2015). Introduction to Balance Sheet. Retrieved on August 5, 2016 from https://www.accountingcoach.com/balance-sheet/explanation Investopedia. (n.d.). Income Statement. Retrieved on August 5, 2016 https://www.investopedia.com/terms/i/incomestatement.asp Investopedia. (2015). Sensitivity Analysis. Retrieved on August 5, 2016 https://www.investopedia.com/terms/s/sensitivityanalysis.asp Stockopedia. (2012). What is a DCF Valuation? Retrieved on August 5, 2016 https://www.stockopedia.com/content/valuation-101-how-to-do-a-discounted-cashflow-analysis-63489/