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Question

CASE STUDY IN FINANCE — Lifestyle Furniture
Lifestyle Furniture is based in the North West of England. The company is one of the leading online of solid hardwood furniture They specia ise in selling the finest Oak, Pine. Indan and Painted Furniture at the bwest pnces on the internet All of the furniture has been crafted from natural wood and und finlshed by skilled craftsmen Each unique piece of fumiture IS made only once.

Lifestye Furniture is proud to offer a large variety of ranges to suit all tastes and budgets. Each range has products to suit every room in the home. The company constanty adds ranges and products. They design their own products, have them hand crafted and made exduslvely by them.

Freddy Smith, the famous designer and the companies founder and CEO, invested his life time savings into the project a few years ago. By the end of 2015 the company had recorded a valuable sales turnover of over $13 million profits n excess ot $1.75 million.

Brad Campbell, the chief financial officer of Lifestyle Furniture, expects the firm’s net profits for the next five years to grow at the rate of 1.29 percent per year. It is assumed that the first year profit of the firm wil be $130,000.

The company’s management wishes to improve its producton line with a proposition to invest in new generation craft machinery. Therefore Brad was asked to develop the relevant cash flow calculations needed to analyse whether to renew or replace Lifetime Furniture’s existing machinery. At the same time L1festyle Furniture hired a
consultant to conduct a feasibiity study for the two alternatives at a cost of $25,000.

An existing machine which onginally cost $30,000 and having a current book value of $0 can now be sold for $20,000. Estmates are tJat at the end of five years the existing machine can be sold for net $2,000 before tax. Current market value of the land already owned by the company is $500,000. The firm is subject to a 30% tax on
both ordinary income and capital gains. The company uses straight line depreciation for tax purposes. Two alternatives beng considered are described below:

Alternative 1
Renew the existing machine at a total cost of $135, 000 The renewed machine would have a fue years usable life and be depreciated using the straight line method over an effective life of five years. Renewing the machine would result in the following revenues and expenses:

1. In the first year sales revenue is estimated at $800,000 dollars. Sales revenues are expended to increase constantly at a rate of 13.5% per annum.
2. The company will set aside $30,000 at the start of each year for additional advertising and marketing expenses for this machinery renewal.
3. Renewal of the madline involves maintenance costs of $42 ,200 per annum payable at the of each.
4. Raw nuterials constitute 32% of total sales per year.
5. Operating costs are calculated as $75,000 per annum.
6. All other expenses ncludng overheads, salaries and other costs of production total $352000 annually.

The renewed machine would result in an immediate inaease of $15,000 in net working capital. At the end of five years, the machine could be sold for $8,000.

Alternative 2:
Replace existing machine with a new machrE costing $225,000 and —Jiring installation of $20,000. The new machine would have a five year usable life and can be depreciated the straight line method over an effective life of five years. The firm’s projected revenue and expenses, it it acquires the machine are as follows:

1. In the first year sales revenue are expected to reach $1 They wil grow at a constant rate Of 13.5% oer annum.
2. The company wil set aside S30,OOO at the start of each year for additional advertising and marketing expenses for this new machinery.
3. The new machine involves maintenance costs ot $38.750 per annum payable at the start of each year.
4. Raw materials constitute 32% of total sales per year.
5. Operating costs are calculated as $58,500 per annum.
6. All other expenses including overheads, salaries and other costs of production amount to $345,000 annually. The machine would result in an increase of $22000 in net working capital. At the end of five years, the new machine could be sold for $25,000.

The firm’s current cost of capital is 17% per annum, comprised of an 11% per annual cost of debt and an 18% annum of equity, In order to finance the refurbishment or purchase of the craft machinery company will have to take out a bank loan. The bank will 6% interest on the loan.

Reference:

1. Calculate the incremental operating net cash flow associated with each alternative (this should be prepared in an excel spreadsheet, with completed work copied across to a word document)

2. Determine the NPV, IRR and Pl for each choice. Based solely on your comparison of the relevant cash flows. which alternatve is better? Why?

3. Draw a NPV profile for each project on the same set of taxes and discuss any confict in that may exist between NPV and IRR Explain any observed contlict in terms of the relative differences in the magnitude and timming of each project’s cash flow.

4. After reviewin the data provided, you realise that cost figures have not been adjusted for inflation which is expected to average 35% p.a. over the long term. Specifically. the advertising costs are expected to
increase at a rate of 4% p a. by the end of the first year. 80th operating and maintenanæ oosts are expected to increase at a rate of 3% pa from the initial cost estimates. This is because these items are largely fixed under contract obligation. The impact of Inflation also affects overheads, salaries and other expense/costs at a rate of 3.5% p.a. by the end of the frst year.

5. Using the base case scenario for Alternative 1 and 2 determine:
a. How low sales revenues will have to fall to,
b. How high operating and maintenance cost will have to rise to the project becomes unfeasible to the company. Discuss how this impacts above recommendations.

6. Without any calculations. the company would also like you to start a preliminary discussion on whether the new generation craft machinery should be leased or purchased outright Your discussion should consider the advantages and disadvantages of adopting an operating or finance lease for the machine. Address how a lease arrangement might change your analyses.

Solution

Lifestyle Furniture, based in the North West of England, is one of a leading company in the business of solid hardwood furniture and it is operated as online retailers. Its management is planning to improve the production line. For this, it is in the course to invest in a new generation craft machine. There are two alternatives. One is alternative 1 to renew the existing one with a total cost of $135,000. Another one is alternative 2 to replace the existing with a new one and it involves the initial cost of $245,000. In case of alternative 2, the old machine will be sold for $20,000 and after-tax it is used to reduce the initial investment of alternative 2. Different costs and expenses, as well as the incremental sales revenues, are associated with each of the alternatives.

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The scenarios of both alternatives have been analyzed. Different evaluation measures such as NPV, IRR, and PI have been calculated for each case.  Sensitivity analysis has been done on both alternatives to see to what extent the alternatives are sensitive to the change in sales revenue, operating cost and maintenance cost. 

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