Case Study of WePROMOTE

Abstract

In this paper, I am going to perform NPV calculations for both plans and explain, how I did them. Then I will try to justify if we should pursue this idea and then will present my logic and arguments behind the conclusion.

NPV is used to determine if a proposed project would be profitable. NPV is calculated by finding out the difference between cash outflow and aggregated future cash inflows (Investopedia, n.d.).

IRR or Internal rate of return is used to estimate the profitability of proposed project/investment. It is a discount rate that makes the NPV of future cash flows to zero (Investopedia, n.d.).

Keywords: NPV, IRR

 

 

 

 

 

 

 

Before we start the NPV calculation, here are the facts we are going to use –

  • The cost to install the required equipment will be $75,000, this is the outflow on year 0
  • Per my business partner, the firm will receive $15,000 annually for 7 years.
  • I think cash inflows will be of $14,000 in years 1-2, then inflows of $15,000 from years 3-4, and then inflows of$17,000 for years 5-7.
  • In 7 years, the equipment will stop working and can be sold for its parts for about $5,000.
  • The Capital cost or Discount rate: 6%
     Rate 6%    
  Approach 1 ( Partner’s Plan)   Approach 2
Year Cash Flow NPV Cash Flow NPV
0 ($75,000) -$75,000.00 -$75,000.00 -$75,000.00
1 $15,000 $14,150.94 $14,000.00 $13,207.55
2 $15,000 $13,349.95 $14,000.00 $12,459.95
3 $15,000 $12,594.29 $15,000.00 $12,594.29
4 $15,000 $11,881.40 $15,000.00 $11,881.40
5 $15,000 $11,208.87 $17,000.00 $12,703.39
6 $15,000 $10,574.41 $17,000.00 $11,984.33
7 $15,000 $9,975.86 $17,000.00 $11,305.97
    $8,735.72   $11,136.88
   
  IRR: 9%   IRR 10%

 

This NPV calculation is not complete without including the $5000 that would be generated from the equipment sale

On year 0 or right away we will invest $75000 that is the cash outflow

We will have to calculate the PV of future cash flow, keeping in mind we will pay 6% on capital

So the we calculate PV of cash flow = Cash flow / (1 + Discount Rate) ^ year

So in approach 1, cash flow in 5th year would be calculated: 15000 / (1+6%) ^5 = 11208.87

And we have applied the formula for each year, and cash flow is same each year in this instance

But for approach 2, the cash flows differ, but we can use the same formula, apply same discount factor, since the cost of capital does not change, neither does the timeline, in both cases the equipment lasts 7 years. And at the end of 7 years, the equipment can be sold for the same amount which is $5000.

Let us do the NPV calculation including the cash that would be generated from the sale of equipment.

In approach 1, or cash flow projection by my friend, the 7th year cash flow will be $20000 ($15000 + $5000)

In approach 2, or cash flow projection by myself, the 7th year cash flow will be $22000 ($17000 + $5000)

 

Year Cash Flow NPV Cash Flow NPV
0 ($75,000) -$75,000.00 -$75,000.00 -$75,000.00
1 $15,000 $14,150.94 $14,000.00 $13,207.55
2 $15,000 $13,349.95 $14,000.00 $12,459.95
3 $15,000 $12,594.29 $15,000.00 $12,594.29
4 $15,000 $11,881.40 $15,000.00 $11,881.40
5 $15,000 $11,208.87 $17,000.00 $12,703.39
6 $15,000 $10,574.41 $17,000.00 $11,984.33
7 $20,000 $13,301.14 $22,000.00 $14,631.26
    $12,061.01   $14,462.17
   
  IRR: 10%   IRR 11%

 

Now including $5000 with the cash flow projected on the 7th year, our NPV and IRR changes.

We use the discount factor because the projected cash flow is in future and Present value of the future cash flow can be determined only if we use the discount factor that is derived from the interest rate and time.

A positive net present value tells us that the projected earnings generated in present value by the project exceed the anticipated costs in present value (Investopedia, n.d.).

            This project is definitely worth considering, since the NPV in both approaches (my partners or mine) greater than 0 that means, this project will yield in positive cash flow and yield better return, in a nutshell, this would be a profitable project.

In approach 1, where cash flow for 7 years would be $15000 and then the equipment can also be sold for $5000, the NPV would be $8,735.72 excluding the cash that would be generated from equipment sell. Including the $5000 from the sale of the equipment the NPV would be $12,061

In approach 2, the cash flow for 1 and 2 years would be $14000, over years 3 – 4 it would be $15000 and over years 5-7 it would be $17000, we have applied the same discounting factor to calculate the PV of those future cash flows and added them up to get the NPV.  The NPV would be $11,136.88, excluding the $5000 that would be generated from the sale of the equipment after 7 years. Including the $5000 from the sale of the equipment the NPV would be $14,462.17

Logical Summary and Conclusion:

The NPVs are positive in both approach, so this is a profitable project, and the company should pursue it. Moreover, if we calculate IRR, we get 10% IRR with approach 1, that my friends approach or cash flow projection and we get 11% IRR with approach 2 or with my cash flow projection. Our cost of capital is 6%, so we get a good return on this project either way.

Now that our NPV and IRR calculation shows that the project will generate profit, we need to keep in mind that my business partner thinks that this project will generate more leads in future, so we should definitely go ahead with this project.

 

 

 

 

 

 

 

References:

Retrieved on 4/21/2018. Retrieve from https://www.investopedia.com/terms/n/npv.asp

Retrieved on 4/21/2018. Retrieved from https://www.investopedia.com/terms/i/irr.asp

 

Impact of depreciation expense has on the cash flow analysis of a capital project

Discuss the impact of depreciation expense has on the cash flow analysis of a capital project.  Also discuss the implications of a leasing arrangement has on depreciation expense.

 

Impact of depreciation expense has on the cash flow analysis of a capital project

Depreciation is a non-cash accounting charge that does not impact direct impact on cash flow, although if a business produces sufficient taxable income, depreciation would reduce it as a tax-deductible expense and that would have a positive impact on cash flow by reducing tax(Investopedia, n.d.).

When a business purchases a long-term asset such as a car, furniture, real estate, computer, equipment etc. it can depreciate the value of it in future years, over the lifespan of the purchased asset.

An important point to remember, land can be part of a long-term asset, but it cannot be depreciated. The long-term asset is usually used to generate income in the long-term that is more than 12 months.

All fixed assets (except land) has a useful life, and business can depreciate the value over the useful life. Business can use “Straight line” method, Declining Balance or units of production approach to depreciating the value of the asset.

Before we go to depreciation, let us quickly see what happens when the business purchases the fixed asset –

The fixed asset can be purchased with the cash in hand, financed by bank or shareholders can loan the money to the business. So after purchasing the fixed asset, it will appear in the balance sheet as a fixed asset, and there might be a drop in cash in the balance sheet(if purchased with the cash in hand/ current asset) or there will be an increase in long-term liability.

Now coming back to how depreciation impacts cash flow –

Depreciation is not a cash outflow so it is added back to net income for each year until the value of the asset depreciates to 0.

For example, say I am a business owner and business needs a laptop. I loan my own money to the business, the laptop costs $1500. We can expect the laptop to be useful for 3 years. We expect the laptop to depreciate in a straight line, so $500 each year and it should generate enough income to cover for its cash. But when I say, depreciation is cash inflow, it is not 100% accurate. It is inflow over the useful life of the asset but there was outflow, the moment the business purchased the asset for $1500. So the inflow in form of depreciation just offsets the initial outflow. And usually the financing term is also for over the useful life term of the asset, so the business has to return the $1500 I gave it over 3 years. I am excluding any interests, since it is my own business, I did not charge any, but in case the business borrows money from a bank, it will pay bank principle + interest over next 3 years.

Just to recap, in year 0, there is a cash outflow of $1500, on year 1 – 3, there will be cash inflow of $500 as depreciation. And the business will pay back the loan it took over 3 years. After the end of year 3, the book value of the laptop becomes 0. Now if the business can sale the laptop, the cash inflow from the sale will be added back to income. But, it the business decides to sell the laptop after the 2nd year when it’s book value is $500 ( after depreciating $1000) and its sales for $700, it will be added to income too. But it will have to pay back the lender first and then anything that is leftover can be considered as profit.

 

Implications of a leasing arrangement have on depreciation expense.

 

            Under certain circumstances a business can show a leased item as an asset on balance sheet that means the business can depreciate the asset (leased item here) and also the interest expense would be recognized on cash flow statement(Investopedia, n.d.).

Here are the situations when a business can recognize a leased item as an asset on balance sheet –

o   The business gains ownership of the leased item after the end of the lease term

o   If the business can buy out the leased item after the lease term is over

o   If the lease term is at least 75% or longer than the useful lifespan of the leased item

o   The lease payment is 90% or higher than the fair market value of the leased item.

 

In this case, the lease obligation is recognized as the cash outflow and over the lifespan of the leased item, the business can recognize depreciation and book value of the leased item or the asset would decline. And the other calculations remain same as what we did for the depreciation of a long-term asset.

 

References:

Retrieved on 4/22/2018. Retrieved from https://www.investopedia.com/terms/c/capitalleasemethod.asp

Retrieved on 4/22/2018. Retrieved from https://www.investopedia.com/ask/answers/080216/how-does-depreciation-affect-cash-flow.asp

 

Case Study of Great Service Cleaning and Maintenance Company

Abstract

This paper will provide a financial ratio analysis of the company using:  Gross profit margin, Current ratio, and Debt ratio, Quick ratio and Interest Coverage ratio. We will look into the significant line items in ‘Balance sheet’ and ‘Income statement’ and we will try to analyze the numbers and trends too.

 

Keywords: gross profit margin, current ratio, debt ratio

 

 

 

 

 

 

 

 

 

 

 

 

We have balance sheet and income statement of Great Service Cleaning and Maintenance Company and we need to find out

  1. Gross Profit Margin
  2. Current Ratio
  3. Debt Ratio

And we will look into the “Quick Ratio” and “Interest Coverage Ratio” too.

Gross Profit Margin

Gross profit margin gives us idea about the money company made from the revenue after covering its cost of goods sold (Investopedia, n.d.).  We have data for year 2013 and 2014, so let us first find out the ‘Gross Profit Margin’ for the year 2013 –

Gross profit margin = gross margin / net sales

In the year 2013 the Company made profit of = $1337600 and the Service contract Revenues was $6295400

Hence the gross profit margin for year 2013 = 6295400 / 1337600 = 4.71 or 47.1%

In the year 2014, the ‘Gross Profit’ was $2196900 and Service Contract Revenues was $9700000

Hench the Gross profit margin for the year 2014 was = 9700000 / 2196900 =4.42 or 44.2%

 

Current Ratio

Current ratio is expressed by = Current Assets / Current Liabilities

Current assets are most liquid assets, such as cash or cash equivalents, payment receivables or inventories. Any asset that can be converted to cash quickly is current asset (Investopedia, n.d.).

Current liabilities are payments to vendors and creditors or any such liabilities, those have to be paid back within a year.

From the Balance sheet we get for the year 2013, the company had current asset worth $ 3726900. And current liability was $ 3092850

Hence, current ratio for the year 2013:  3726900 / 3092850 = 1.2

For the year 2014, total current asset was worth $ 4602200 and total current liability was worth

$3125950

Current ratio for year 2014: 4602200/3125950 = 1.47

Debt Ratio

The debt ratio helps us understand how much of company’s assets are financed by debt (Investopedia, n.d.).

In the year 2013, the company’s total debt was = $5025400 and total assets was $3667900

So for year 2013, the debt ratio was = 5025400 / 3667900 = 1.37 or 13.7%

In year 2014, total assets was $5957800 and total debt was $3770300

So. The debt ratio of 2014 was = 5957800 / 3770300 = 1.58 or 15.8%

 

Quick Ratio:

Quick ratio is another way or most prominent way to find out if the company has enough liquid assets excluding inventory to meet its short term obligation (Investopedia, n.d.).

Quick Ratio = (Current Assets – Inventory) / Current Liability

The quick ratio for 2013 was: (3726900 – 100200) / 3092850 = 1.17 or 11.7%

The quick ratio for the year 2014 was: (4602200 – 89800)/ 3125950 = 1.44 or 14.4%

Interest Coverage Ratio:

This is used to determine how easily company can pay the interest on the debts it has (Investopedia, n.d.).

Interest coverage ratio = Earnings before interest and taxes / Interest expenses

Interest Coverage ratio for 2013: (581600+7700) / 70800 = 8.32

Interest Coverage ratio for 2014: (1300900+59900) / 69500 = 19.58

 

 

 

 

Significant line items from Balance Sheet –

Cash reserve has increase by 105% year on year. Which is good, especially when inventory has gone down by 10% that means, the sales are going up. And total current assets have gone up by 23% while inventory has gone down, that means, company is selling their service well.

Total assets have gone up by 18% but long term liability has gone up by 12%.The business is investing, but the increase is mostly concentrated in long term notes.

The retained earnings have gone up too and so did stockholders equity by 61%. The company is profitable and had good cash flow.

Total liability is up by 2.79%, that is not very significant, but it means, the company is not trying to pay down the debts.

From Income Statement the significant lines are –

The Revenue has increased by 54%, which is okay, not that great, but the gross profit margin has gone down from 2013 to 2014.

Gross profit has also increased in 2014 by 64%.  Net income has a good increase by 437%. One major chunk is coming from their equipment sell.

 

 

 

Conclusion –

The increase in cash (by 105.26%) and drop in inventory (10%) shows us, the sale is great, and we can see the same in revenue increase and gross profit increase (by 64%). We can see the Gross profit margin changing from 47.1% to 44.2%.

The company’s total assets have gone up by almost 18.55%. Which is good, cash has doubled, which is great. Although the company has sold some of its equipment, hence we see a drop is long term asset in equipment by 4.2%, but it has a significant increase in note receivables by 35.59%.  May be the company is trying to get rid of its old equipment that it does not use anymore, and trying raise cash selling  those. The company sold equipment in 2013 and 2014, we should find out if they have the equipment they would need or if they are planning to rent in future instead of owning.

I would like to know the reason behind the increase in long term asset -“Note receivable” while there is an increase in long term liability by 31.46%, we need to understand why the company had this increase, and why dint they pay down some debts? Especially when the Debt Ratio has increased from – 13.7% to 15.8%.  The retained earnings is up, the cash holding is up, but why they did not pay off some off their long term debts? And they are selling their equipment and investing in long term notes, are they making more in interest than what they are paying for the liabilities they have?

The company is doing well in terms of sales, but it could do better in paying off debts, and reducing costs, as we can see service contract costs have increased by 51.33%. Their Gross profit margin is dropping, which needs attention too, how can they reduce cost, options should be explored.

References

Retrieved on 4/17/2018. Retrieved from https://www.investopedia.com/terms/d/debtratio.asp

Retrieved on 4/17/2018. Retrieved from https://www.investopedia.com/terms/g/gross_profit_margin.asp

Retrieved on 4/17/2018. Retrieved from https://www.investopedia.com/terms/q/quickratio.asp

Retrieved on 4/17/2018. Retrieved from https://www.investopedia.com/terms/i/interestcoverageratio.asp

Retrieved on 4/17/2018. Retrieved from https://www.investopedia.com/terms/g/gross_profit_margin.asp

 

 

financial ratio analysis of the company using the following ratios: (1) Gross profit margin, (2) Current ratio, and (3) Debt ratio.

Please refer to the income statement and balance sheet for the Great Service Cleaning and Maintenance Company

  • Perform a financial ratio analysis of the company using the following ratios: (1) Gross profit margin, (2) Current ratio, and (3) Debt ratio. From research independent from the textbook, find two other ratios to calculate. Define them and explain their purpose and how they add value to your analysis.
  • Select significant lines from the financial statements and provide an observation of their trends (Is the account increasing or decreasing in value? What does this mean?)
  • Draw some conclusions based on your observations. For instance, why do you think the assets of the company went up from 2013 to 2014? What implications does this have? What follow-up questions do you have to ask the company’s management?
  • Support your observations with data and logic. Discuss what limitations exist with the informational material provided. What other material would be important to your trend analysis?

 

 

 

 

 

We have balance sheet and income statement of Great Service Cleaning and Maintenance Company and we need to find out

  1. Gross Profit Margin
  2. Current Ratio
  3. Debt Ratio

 

 

 

 

Gross Profit Margin

 

We have data for year 2013 and 2014, so let us first find out the ‘Gross Profit Margin’ for the year 2013 –

Gross profit margin = gross margin / net sales

In the year 2013 the Company made profit of = $1337600 and the Service contract Revenues was $6295400

Hence the gross profit margin for year 2013 = 6295400 / 1337600 =

In the year 2014, the ‘Gross Profit’ was $2196900 and Service Contract Revenues was $9700000

Hench the Gross profit margin for the year 2014 was = 9700000/2196900 =

 

Current Ratio

Current ratio = Current Assets / Current Liabilities

Current assets are most liquid assets, such as cash or cash equivalents, payment receivables or inventories. Any asset that can be converted to cash quickly is current asset.

Current liabilities are payments to vendors and creditors or any such liabilities, those have to be paid back within a year.

From the Balance sheet we get for the year 2013, the company had current asset worth $ 3726900

And current liability was $ 3092850

Hence, current ratio for the year 2013 :  3726900 / 3092850 =

For the year 2014, total current asset was worth $ 4602200 and total current liability was worth

$3125950

Current ratio for year 2014: 4602200/3125950 =

Debt Ratio

 

The debt ratio helps us understand how much of company’s assets are financed by debt.

In the year 2013, the company’s total debt was = $5025400 and total assets was $3667900

So for year 2013, the debt ratio was = 5025400 / 3667900 =

In year 2014, total assets was $5957800 and total debt was $3770300

 

So. The debt ratio of 2014 was = 5957800 / 3770300 =

Significant line items from Balance Sheet –

Cash reserve has increase by 105% year on year. Which is good, especially when inventory has gone down by 10%, that most probably means, the sales are going up. And total current assets have gone up by 23% while inventory has gone down, that means, company is selling their service well.

Total assets have gone up by 18% but long term liability has gone up by 12%.The business is investing to grow.

The retained earnings have gone up too and so did stockholders equity by 61%. The company is profitable and had good cash flow.

Total liability is up by 2.79%, that is not very significant, but it means, the company is not trying hard to pay down the debts.

From Income Statement the significant lines are –

The Revenue has increased by 54%, which is okay, not that great, but at least the company has generated more revenue in year 2014.

Gross profit has also increased in 2014 by 64%.  Net income has a good increase by 437%. One major chunk is coming from their equipment sell..

 

Conclusion –

The increase in cash (by 105.26%) and drop in inventory (10%) shows us, the sale is great, and we can see the same in revenue increase and gross profit increase (by 64%).

The company’s total assets have gone up by almost 18.55%. Which is good, but cash has doubled, which is great. Although the company has sold some of its equipment, hence we see a drop is long term asset in equipment by 4.2%, but it has a significant increase in note receivables by 35.59%.  May be the company is try to get rid of its old equipment that it does not use anymore, and trying raise cash selling  those. The company sold equipment in 2013 and 2014, we should find out if they have the equipment they would need or are they planning to rent in future instead of owning.

I would like to know the reason behind the increase in “Note receivable” and there is a increase in long term liability by 31.46%, we need to understand why the company has this increase, and where did they use this fund? The retained earnings is up, the cash holding is up, but why they did not pay off some off their long term debts? And they are selling their equipment and investing in long term notes, are they making more in interest than what they are paying for the liabilities they have?

The company is doing well in terms of sales, but it could do better in paying off debts, and reducing costs, as we can see service contract costs have increased by 51.33%.

Please research and then discuss the aspects of the bankruptcy process. Also, discuss capital structure and how a company’s structure impacts its progress through the bankruptcy process.

Please research and then discuss the aspects of the bankruptcy process. Also, discuss capital structure and how a company’s structure impacts its progress through the bankruptcy process.

 

A company might need to file bankruptcy because of economic reason or financial reasons. Some businesses owe way too much than they can ever pay back, and at times interests payment on debts make it impossible to return to profit, then bankruptcy might be a viable option to return to profit and grow shareholder wealth. And another scenario can be, a company or service that is not relevant anymore, such as Toys R US, the industry is disrupted by online stores and the industry could not keep up, so they are going out of business.

A financially stressed company can consider filing for Chapter 7 or Chapter 11 bankruptcy in US. These 2 types are very different than each other and the creditors or equity holders are also affected differently.

Chapter 7 – in this case company goes out of business and they liquidate all their assets. The money generated from the liquidation is used to pay of the debts(Investopedia, n.d.). But not all debts are treated equally. Senior debt or secured debt get first priority to be paid off, so these types of debts are most secured but they usually come with low interest rates. After secured debts are paid off the money goes to pay off junior debt or unsecured debts and equity stock holders come last. The unsecured bond / debt holder own more risk than senior and secured debt / bond holders, so they earn more interest. After paying off all debts/bonds if anything remains leftover then that amount goes towards paying equity owner.

Chapter 11 – Companies apply for chapter 11 to restructure their debt / equity. And in this case Companies do not liquidate their assets. Because the company does not go out of business, so they do not sell their core assets. But to remain financially solvent the company goes through debt restructuring (Investopedia, n.d.).

Due to the complexity and expenses this type is often the last option. In Chapter 11 all debtholders and equity holders are represented by members in a committee, formed with a purpose to reduce debt and make the company profitable, while protecting the debt and equity owners’ interest as much as possible. But under Chapter 11, stock holders may not get any money and bond holders might get equity stake instead in new restructured company. And often all the stakeholders end up taking haircuts on their holdings and the new entity might require capital infusion.

Capital Structure is how a company finances its operations, such as purchasing assets or running day to day business. And a company can finance its activities with bonds, long term notes or selling equity / stocks in capital markets (Investopedia, n.d.). In current low interest rate environment most companies find it cheaper to finance with debt.

Companies prefer debt over selling equity, especially when growth is accelerating. Paying interest helps save taxes too. Selling equity is another option where stock holders participates in company’s upside and downside and this is most risky form of investment for. If company does well, equity holders get a part of profit, but there is no promise of interest payment like bonds.

When a company files of Chapter 7 bankruptcy and liquidates all the assets, the company stops all operations and goes completely out of business (SEC, 2009).AS we have seen before in this case the bondholders have higher chance of recovering their investments than the stockholders. This is comparatively simple, although it is never good for investors, but equity stock holders stand the chance to lose most. During bankruptcy bondholders do not receive any interest payment or stockholders do not receive any dividend payments. In case of Chapter 11, the equity stock holders might get shares in the new entity but one thing is for certain, they take a major hit on their initial investment.

 

References:

Retrieved on 04/14/2018. Retrieved from https://www.sec.gov/reportspubs/investor-publications/investorpubsbankrupthtm.html

Retrieved on 4/14/2018. Retrieved from https://www.investopedia.com/terms/c/capitalstructure.asp

Retrieved on 4/14/2018. Retrieved from https://www.investopedia.com/articles/01/120501.asp