Financial Break-Even at Rediform Concrete - Case Study Example

Rediform Concrete’s Break- Even Analysis Introduction Rediform Concrete is considering a $5 million capital investment for a factory to manufacture formed concrete products, such as patio stones, mobile home stones, and lawn decorations. The proposed factory will generate annual sales between $2 million and $5 million. After-tax fixed costs are 0k per year and after-tax variable costs are 50% of sales. Therefore, annual after-tax cash flow for the project is (0.5) sales. The expected life of the project is 5 years and the salvage value depends on land prices at the end of five years. The factory would be built on Palmetto Rd., near the Sunshine Expressway. A new freeway exit is being planned for the Sunshine Expressway. If the exit is built at Palmetto Rd., the salvage value of the factory will be $3 million. If the exit is located at one of the two competing roads, the salvage value will be $1 million. Ignore the depreciation in your calculations. OTHER DATA: The firm has estimated the level of systematic risk to be Batap= 0.75, the expect return on the market is (bar Rm) = 12%, and the risk-free rate of return is Rf= 4% Prepare an analysis that examines the economic break-even for this project. Also, prepare an analysis that examines the project's sensitivity to salvage value. Summary: Capital ventures are treated like black boxes. In a hypothetical situation we consider that managers are provided unbiased cash-flow estimate and their only assignment is to evaluate risk, choose the correct discount rate, and find out the net present value. However, in a real world case, actual financial managers won’t relax until they get to know what makes the project right and what could be a blunder with the project. Although the risk of the project can be diversified, still one needs to understand what reason behind the failure of the project is. Once it is identified then it becomes easy for one how to find solution of the uncertainty. One need to know the warnings and steps one should take up. The project with a negative Net Present Value (NPV) needs more treatment (Brealey and Myers, 1993, pp-225). By NPV we mean the difference between the present value of cash inflows and outflows. This criterion is used in capital budgeting decision to estimate the profitability of any venture. The formula is given by: NPV = C1/ (1+r) + C2/ (1+r) 2 + C3/ (1+r) 3+…… (Brealey and Myers, 1993, pp-15). Where C0 is the initial cash flow, but it is not considered. C0 is said to be negative as this cash flow is an investment, that is, it is a cash outflow. C1 is the cash flow received by the investor in the first year, C2 is the cash flow in the second year and so on.; r is the discount rate which is determined by the prevailing market rates. Discounted-cash-flow analysis ascertains that companies possess assets indifferently, and it avoids the possible choices to expand the venture if it is profitable or to rescue if it is not. However, the reasonable managers appraise these opportunities. They look for the methods to finance so that it turns out to be a successful venture and to minimize the expenses of failure, and they are ready to undertake such ventures which provide them adjustability (Brealey and Myers, 1993, pp-225). There are three criteria to find out NPV. Often the managers adopt the methods of analysis like sensitivity analysis, scenario analysis or break- even analysis. Sensitivity analysis is an approach used to find out how different values of an explanatory variable will affect a particular explained variable under some specified assumptions. This method is used within certain limits which depend on one or more input variables like what will be the effect on the price of the bond when interest rate changes. It is a method of predicting a result of a situation if the situation turns out to be different from what was previously considered. The analysis is based on the changes on the one variable having impact on the target variable. However, there are certain flaws associated with the sensitivity analysis; one flaw is that it sometimes provides contradictory results. It incorporates subjective probabilities, however, option of optimism and pessimism vary from person to person. Another drawback is it changes one variable keeping other things constant but in actual it odes not happen. As for example, the cost of production will definitely affect the level of production (Sensitivity Analysis, n.d.). Scenario Analysis is the process of computing the expected value of a portfolio after a certain given period of time. This analysis mainly stresses on what will be the value of a portfolio during the worst possible situation. It basically deals in calculating the rates of reinvestment for the expected returns. A basic way to apply the scenario analysis is to calculate the standard deviation of the returns from securities either daily or monthly and after that deduce the expected value of the portfolio. A certainty can be ensured that the value of the portfolio is not going to rise above or fall below a particular value within a given time period (Scenario Analysis, n.d.). In this project we will lay stress on the break- even analysis. By break- even point we mean that it is a point below which a firm would never want to go. It serves as a limit. Every firm tries to find out the break- even point beyond which a firm would definitely make losses. Break even analysis is an analysis by which the managers want to know how much the situation can get worse if the venture starts losing money. Mostly the managers compute the break-even points in regard to the estimated profits rather than the present value Companies that break even on an accounting sense are in fact incurring loss that means, while investing they are losing the opportunity cost of capital. There will be some inflow and outflows of cash in the company. As long as the present value of inflow is greater than the present value of the outflow, the NPV will remain positive as revenue exceeds cost. After a certain amount of sales, the cost of production will increase but the sales that is, the inflows are not increasing which implies that the market is getting saturated and the firm is not being able to sell its production in the market. Ultimately situation will come when the present value of inflow will be less than the present value of outflow, thus NPV will turn out to be negative. When NPV is equal to zero, then that will be the break- even point of the firm. Figure 1. A break- even chart showing the present value of inflows and outflows of cash. (Brealey and Myers, 1993, pp-261) In a cost- volume profit analysis model, the break- even point is calculated in terms of revenue and cost. It is given as:- TR=TC Or, P*Q =TFC + TVC = TFC + VC*Q Or, (P-VC)*Q= TFC Or, Q= TFC/ (P-VC) Where, Q is the quantity of output, P is the price of the good per unit of output, VC is the variable cost and TFC is the total fixed cost. Statement of problem: In this analysis we will try to find out the economic break- even for this project. By the help of the Capital Asset pricing Model (CAPM) we will find out the rate of return, r. for pricing the risky securities, the CAPM is used to understand the relationship between the risk and the expected return. Analysis and Methodology: The investors take higher risk in order to get higher return from the market. The difference between the market return and the rate of interest is known as the market risk premium which is termed as (rm- rf). In a competitive framework, the expected risk premium varies directly with the β which is a measure of risk. Hence all the investments should be undertaken on the security market line (SML). The entire investment portfolio must be plotted along the slope of the SML. The x- axis represents β and y- axis represents the expected return (Brealey and Myers, 1993, pp-195). Expected Return on Investment Security Market Line (SML) rm rf Beta (β) Figure 2. Diagrammatic Representation of the Security Market line (Brealey and Myers, 1993, pp-195) The relationship can be written as: r- rf = β (rm- rf) (Brealey and Myers, 1993, p.195). Where, rf is the risk free rate; rm is the expected return on market; r- rf is the expected risk premium on stocks; (rm- rf) is the expected risk premium on market. In the present situation Rediform Concrete has estimated the level of systematic risk to be β = 0.75, the expect return on the market is (bar rm) = 12%, and the risk-free rate of return is rf = 4%. Thus, the rate of return would be r= β (rm- rf) + rf . = 0.75*(12%-4%) + 4%. = 0.75* 0.08+0.04 = 0.06+0.04 = 0.10. The rate of return, r will be 10%. Rediform Concrete will generate annual sales between $2 million to $5 million. As we do not know the exact figure hence we are considering the annual sales of the firm as x (say).It has been said that after tax the fixed costs are ok per year and after tax the variable costs are 50% of sales that means we can write that as 0.5*x. Thus the annual after tax cash flow which is the net cash flow will be 0.5*x. The initial amount of capital investment is given as $5 million. The expected life of the project is given as 5 years. The net profit will be (x-0.5*x). As we know that the rate of growth of annual sales cannot be same over the years, thus we are hypothetically assuming that the rate of growth of x is 5%. NPV = -5 +Σi5 (0.5*x*(1+0.05)i )/ (1+0.10)i $ million . = -5 +Σi5 (0.5*x*(1+0.05)i )/ (1.1) i $ million . In case of a perfectly competitive firm, the firm break-even when the total revenue is equal to the total cost. We know that the pure economic profit vanishes in the long run equilibrium. The long run is a situation where all the inputs are variables. In this situation, a firm has a larger number of options like it can change its output or plant size. The fixed input can also be changed. Even after changing the plant size if a firm cannot cover its total cost (TC), then it has the option to go out from the industry. No firm can exist as it cannot incur losses. Since in a perfectly competitive firm there is freedom of entry and exit, if the existing firm’s revenue exceeds the cost of production, then it earns pure economic profit that is, total revenue exceeds total cost, (TR>TC). It implies that profit can be made in this industry. Other firms will be lured by the profit of this industry and will enter into this industry. The firms will earn pure economic profit in a situation of unstable equilibrium as price is greater than the long run average cost, (P>LAC). In such a case the supply curve of the industry will shift to the right and entry of the firms will go on. As this continues, the price will go down until the pure economic profit vanishes in the long run. The supply curve will shift to the right so that the price falls below the minimum point of LAC. As a result the firms will start leaving the industry. This is how the industry reaches the equilibrium position. This does not necessarily mean that accounting profit is not equal to zero. Accounting profit may not accurately reflect economic profit as accounting profit includes only explicit costs of production (Gould and Ferguson, 1980). Price Short run Average Total cost Marginal Cost (MC) Long Run Average Cost (LAC) P Marginal Revenue (MR) 0 Q Units of output Figure 3. Graphical Illustration of Long Run equilibrium of an individual firm in a perfectly competitive market In Figure 3., Q is the profit maximizing level of output where marginal cost equals the marginal revenue As the firm's average total costs per unit of production is equal to the its marginal revenue, the firm is earning zero economic profits. Furthermore, it is producing at the minimum point of its long-run average total cost (LAC) curve at the minimum efficient scale level of output (Long Run Supply, n.d.). Discussion of results The reason for vanishing of super-normal profit is not due to the inefficiency of the firm but because of the competitive nature of the market. The firm always attempts to capture the pure economic profit. This effort leads to vanishing of pure economic profit in the long run equilibrium. This primarily occurs because of the entry and exit of firms which is the key element of perfect competition. Economic profit takes account of opportunity costs of production. The opportunity cost of an input is the value that is able to earn in its next best alternative use. In the long run equilibrium, the price is tangent to minimum of LAC means pure economic profit is zero. LAC covers all the opportunity costs of production and since P=LAC, we say that firm is able to cover all its opportunity costs. It means that each factor gets the maximum what it could have earned elsewhere at the best alternative use. That is why the firm is able to cover its total opportunity cost of production. If the firm breaks even then NPV will be equal to zero, hence we can write: -5 + Σi5 (0.5*x*(1+0.05)i )/ (1+0.10)i = 0 Or, Σi5 (0.5*x*(1.05)i)/ (1.1)i= 5 Or, 0.5x(1.05/1.1) + 0.5x(1.05/1.1)2 + 0.5x(1.05/1.1)3 + 0.5x(1.05/1.1)4 + 0.5x(1.05/1.1)5= 5 Or, 0.5x*4.358=5 Or, 2.18*x=5 Or, x= 2.29 $ million. Thus we derive the exact amount of annual sales of the firm which is $2.29 million which lies between $2 million and $5 million. The net profit is also (2.29-0.5*2.29) million $ = $1.145 million. The net cash flow is also $1.145 million. After tax the variable costs are 50% of sales which is too $1.145 million. We can draw conclusion that the break- even in sales will be 2.29 $ million. Now we will be incorporating salvage value into our analysis. By salvage value we mean the scrap value of any factory buildings or machineries. In our analysis we will check whether it is economically viable to set up the exit at Palmetto Rd or at one of the two competing roads. Case- I: If the exit is built at Palmetto Rd., the salvage value of the factory will be $3 million. We will try to find out how much of sales a firm needs to generate more in order to keep up with the salvage value. To check this, we will use the formula of NPV and equate it with the salvage value in order to derive the annual sales of the firm. -5 + Σi5 (0.5*x*(1+0.05)i )/ (1+0.10)i = 3 Or, Σi5 (0.5*x*(1+0.05)i )/ (1+0.10)i= 8 Or, 0.5*4.358*x= 8 Or, 2.18*x=8 Or, x= 3.67 $ million. Hence if the exit is built at Palmetto Rd, then the annual sales of the firm generated will be 3.67 $ million. Case II: If the exit is located at one of the two competing roads, the salvage value will be $1 million. Once again we will apply the same procedure. -5 + Σi5 (0.5*x*(1+0.05)i )/ (1+0.10)i = 1 Or, Σi5 (0.5*x*(1+0.05)i )/ (1+0.10)i= 6 Or, 0.5*4.358*x= 6 Or, 2.18*x=6 Or, x= 2.75 $ million. Hence if the exit is built at one of the two competing roads, then the annual sales of the firm generated will be 2.75 $ million. In the Case I if the salvage value is 3 $ million, then the firm need to generate (3.67-2.29= 1.38) $ million. In Case II if the salvage value is 1 $ million, then the firm need to generate (2.75-2.29= 0.46) $ million. The more the salvage value, the more will be the sales generation from the firm’s side in order to meet the sales revenue. Comparing the two cases we analyze that the second option is better than the first one. If the exit is built at one of the two competing roads, then the firm has to generate 0.46 $ million more of salvage value in order to meet the annul sales compared to the first case where 1.38 $ million more of annual sales is required to generate. Conclusion: Hence, a firm tries to compute its break even point to know whether it will be profitable for a firm to sell a proposed product into the market. This analysis is also done to know the profitability of the expense incurred by sales based business ventures. Break even is given by this formula: Break even point in sales = FC/ (Selling price-Variable cost). In the capital budgeting decision, break even is a special application of the sensitivity analysis. It helps to find the values of the variables in which the project’s NPV will be equal to zero. In our above analysis, after incorporating the salvage value into our project, we find that the annual sales in both the cases are greater than the sales when the firm breaks even. In the break even situation, Rediform Concrete is earning a normal profit where annual sales amounted to 2.29 $ million which lies in between the given annual sales of 2 $ million to 5 $ million. Adding the salvage value in the 1st case when the exit is build at the Palmetto Rd, the annual sales amounts to 3.67 $ million and in the 2nd case, the annual sales is 2.75 $ million. Thus we observe that the firm, Rediform Concrete will be in a profitable position if it chooses the 2nd option, that is, if it builds the freeway exit of the factory at Sunshine Expressway at the two of the competing roads. Then it has to generate less amount of 0.46 $ million to meet the sales revenue compared to the 1st option where 1.38 $ million more of money the firm would have to generate. References: 1. Brealey, R, Myers, S (1993). Principles of Corporate Finance, McGraw-Hill, US. 2. Capital Asset Pricing Model – CAPM (n.d.). Investopedia, available at: http://www.investopedia.com/terms/c/capm.asp (Accessed on June 9, 2009). 3. Gould, J, Ferguson, C (1980). Microeconomic theory. R. D. Irwin, US 4. Long Run Supply (n.d.). Cliffs Notes, available at: http://www.cliffsnotes.com/WileyCDA/CliffsReviewTopic/LongRun-Supply.topicArticleId-9789,articleId-9765.html (Accessed on June 11, 2009). 5. Net Present Value - NPV (n.d.). Investopedia, available at: http://www.investopedia.com/terms/n/npv.asp (Accessed on June 9, 2009). 6. NPV (n.d.), available at: http://moneyterms.co.uk/npv/ (Accessed on June 9, 2009). 7. Scenario Analysis (n.d.). Investopedia, available at: http://www.investopedia.com/terms/s/scenario_analysis.asp (Accessed on June 9, 2009). 8. Sensitivity Analysis (n.d.). Investopedia, available at: http://www.investopedia.com/terms/s/sensitivityanalysis.asp (Accessed on June 9, 2009). Read More