Financial Feasibility Of The Business Assessment Answer

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 packaging 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. Fanny’s 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 Shareholder’s Equity

For any Balance Sheet, Assets = Liabilities + Shareholder’s 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 shareholder’s 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.

Shareholder’s Equity: The Shareholder’s 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 Shareholder’s 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/

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