Page 174 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 7: Concept of Leverages

Most of RKV’s financial planning is done by George Lee, GM of finance. Lee has recently Notes
prepared financial statements estimating next year’s operating results. He believes that,
the firm will earn just over $800,000 in the current year on sales of $8 million and is
forecasting sales of $13 million next year. It is likely, that variable costs will remain at
approximately the same percentage of sales next year as this year. Fixed costs will probably
rise to 12 per cent next year.
Company A has an EBIT of $2.6 million, no debt, $8 in equity (300,000 shares), $18 million.
Company B has the same level of sales, an EBIT of $2.85 million, $3.3 and sales of debt at
11 per cent, and $8 in equity (300,000 shares). The tax rate is 35 per cent.
RKV has been investigating the addition of a number of new product lines to be sold
through its existing distribution channels. Two items have been of particular interest. The
first would involve the production and sale of chaise lounges for use around swimming
pools. The product would be aimed at commercial users, such as hotels, but could be sold
through hardware and discount stores as a residential product. The second new item
would be a patio umbrella. The umbrella would be a large, 12-rib, multicolored canvas
with fringe and would be aimed at the residential market. Both products would fit in with
RKV’s existing product line and neither would require any increase in networking capital.

In his analysis regarding the new product proposals, George Lee recognized that, the firm
would have to build new facilities to produce each product. The lounges would require an
investment of $3.8 million which would include the purchase and installation of
manufacturing and packaging machinery. The umbrellas, although a relatively simple
concept, would require an investment of $6 million for efficient production. For both
products, it would take 80 days to install the equipment. This means that production could
begin by January 1st.
Len Haton, the firm’s vice-president of sales, has prepared sales estimates for the two
products. He forecasts $4 million in sales for the lounges and $ 4.3 million in sales for the
umbrellas on annual basis. The report from the cost accounting department estimates
variable costs of two-third of the sales value for the lounge unit and 61 per cent for the
umbrellas. Fixed costs would be $400,000 and $ 650,000, respectively.
To finance the new projects, Lee has been working with Lucid’s investment bankers. At a
recent meeting, Lee was told that the firm could raise money from two sources under the
current market conditions. First, it could borrow on an 11 year note at 12 per cent for either
or both the projects in an amount not exceeding $ 8.5 million. Second, the investment
bankers felt confident that they could underwrite a preferred stock issue with a 12 per cent
dividend up to a dollar amount of $6 million. The issue would have to be cumulative with
respect to dividends. Common stock financing would not be a possibility at present.
RKV Balance Sheet (Projected through December 31 this Year)
Cash $ 425,000
Accounts receivables 750,000
Inventory 500,000
Fixed Assets 7,650,000
$ 9,325,000
Current liabilities $ 600,000
Long-term debt (10%) 3,800,000
Common stock ($3 par) 1,500,000
Retained earnings 3,425,000
$ 9,325,000

Contd...

LOVELY PROFESSIONAL UNIVERSITY 169