The Situation of a Company Hanson Private Limited - Assignment Example

Table of Contents Executive Summary 2 Introduction 3 2.Key issues and risks 3 2 Large size of investment 4 2.2.Short Payback Period 4 2.3.Large debt requirement 4 2.4.Intense Competition 4 2.5.Stagnant growth in market 5 2.6.Method of evaluation 5 3.Key positives 6 3.1.Huge customer base 6 3.2.Deterrent for other private label manufacturers 6 4.Financial Analysis 7 4.1.WACC and Discount Rate 7 4.2.Limitations of Dowling’s approach 7 4.3.Cash Flow and NPV analysis 9 4.4.Validation of Gate’s projections and Sensitivity Analysis 9 5.Key Options & Recommendations 13 References 14 Executive Summary The report assesses the situation of a company Hanson Private Limited (HPL), which produces private label products for a number of retailers. Trucker Hanson, the owner (supposedly), is facing a dilemma over investment into a proposal put forward by HPL’s largest retail customer. According to it, the retailer would increase its dependence on HPL for manufacturing private label products to a large extent. This would require an investment above $50,000 by HPL which is unprecedented in its history. Hanson’s executives have made cash flow and WACC projections using their traditional estimates as well as some external consulting with banks etc. However, Trucker Hanson is not sure of their methodologies and needs to review it. The initial part of the report performs a qualitative analysis of the company where the key risks and positives for the company are identified. The report then delves into financial analysis where the WACC and cash flow calculations are done. The limitations of these analyses are also discussed. Thereafter, the sensitivity of NPV to various factors is discussed. Finally, the key options in front of Hanson and the corresponding recommendations are discussed. 1. Introduction Hansson Private Label (HPL) is a firm which is exclusively into the manufacturing of private label products for large retailers and supermarkets. Hanson had 4 plants operating above 90% capacity. HPL’s largest retail customer has put a proposal in front of the company to make a significant increase in HPL’s share of their private label business. This calls for an investment of more than $50 million as a new production facility has to be developed. Also the retail customer can commit only for a three year contract. Hanson’s managers and executives have tried to evaluate the proposal from various dimensions. However, Tucker Hanson faces a lot of unresolved issues and needs to come to a decision quickly. However, the market growth is quite small and driven by price rise. 2. Key issues and risks The key issues faced by Hanson Private Limited and the risks involved are discussed below: 2.1. Large size of investment The biggest issue HPL faces is regarding the size of the investment. The company has never made such a large investment in a single project at one go. This would practically stall investments into all other projects in the pipeline for the medium term. Hence, the company is not in a position to afford any failure in this project. 2.2. Short Payback Period The retail partner is willing to agree to a 3 year contract only. However, with such a large investment, there is a risk of not getting the money back within 3 years. It is possible that the products fail or are rendered obsolete at the end of 3 years. 2.3. Large debt requirement The company faces a risk of debt trap. Right now, HPL maintains a highly favorable debt position. For adding new capacity, there are constraints in raising money through equity and almost all the financing will have to be done through debt. This raises the risk exposure of the company enormously. 2.4. Intense Competition Hanson manufactures private label products in the personal care space where the competition is very intense. A large number of branded and non-branded companies are vying for a limited shelf space. Hanson already covers 28% of the private label market in personal care space. Therefore, there is a limit to the scope of further acquiring the market share. 2.5. Stagnant growth in market The personal care market volumes have increased less than 1% in the past 4 years. The marginal growth (1.7%) has been largely driven by the price increases. However, one of the biggest USPs of private label products has been their low prices as compared to the branded ones. In such a stagnant growth scenario, expecting large returns from such a large investment within a short period could be a risky proposition. 2.6. Method of evaluation Last but not the least, the company faces issues in how to evaluate the proposal. There are many dimensions which have to be considered before arriving at a decision. The biggest concern is the discount rate. The conventional approach has been to use the WACC of the company as discount rate. But with such a large debt which totally changes the Debt-Equity equation, taking traditional WACC could be tricky. Another big issue is the time frame which they should use for evaluation. 3. Key positives There are certain factors which favor an investment in the proposal presented by HPL’s largest retail customer. These are discussed below. 3.1. Huge customer base HPL had all major national and regional retailers as their customers. Therefore, it was unlikely that the new investment would yield returns only for the largest retailer. The company could leverage the new capacity to clinch deals with other retailers as well in the medium term. 3.2. Deterrent for other private label manufacturers The private label manufacturers in general had a small scale and were not very willing to expand their capacities. HPL’s multi-year contract with a large retailer could act as a further deterrent to increase capacity. Moreover, it may make private labels more acceptable to consumers due to greater penetration. 4. Financial Analysis 4.1. WACC and Discount Rate According to Shelia Dowling’s estimates, the total estimated debt if the proposal is accepted would be $107.6K and the D/V percentage would be 20.9%. This implies that equity would form the remaining 79.1% of total capital. The estimated average cost of equity (from Exhibit 7) is 10.86%. Therefore, WACC can be calculated by taking a weighted mean of the cost of equity and cost of debt (after discounting tax). This value comes out as 9.56%. This value of WACC is the discounted rate of return which can be used for cash flow and Net Present Value analysis. The calculations are shown in Table 4.1.1. 4.2. Limitations of Dowling’s approach Dowling uses the data from similar competitive firms to arrive at average cost of equity and debt. However, the capital structure of these firms may be significantly different from that of HPL. Moreover, after the new proposal, the debt structure would change significantly. Table 4.1.1: Calculation of WACC using Shelia Dowling’s estimates Assumptions: 10-Year Treasury 3.75% Market Risk Premium 5.00%     Tax Rate 40.0%     Est. Hansson EBITDA Multiple 7.0x Est. Hansson Enterprise Value 514.5             Calculations: Existing Net Debt 49.8 Plus: New Expansion Debt 57.8 Total Estimated Debt 107.6     Existing D/V 9.7% Estimated New D/V 20.9%     Assumed Debt Beta 0.00 Estimated Cost of Debt 7.75%     Estimated new E/V 79.1% Estimated cost of Equity 10.86%     WACC     9.56% Another approach could be to use the company’s capital structure data for the past years and the cost of debt and equity used. This approach removes the limitation of a different capital structure but still can’t remove the limitation due to new proposal. However, Dowling has taken cost of debt after consulting the banks and the value of D/V has been taken after considering new debt. Therefore, her assumptions seem reasonable in this respect. 4.3. Cash Flow and NPV analysis Using the value for Discount rate as calculated above, the cash flows for the next 10 years can be calculated as shown in Figure 4.3.1. In this analysis, the initial capital investment has been included while the scrap value of the machine if sold at the end of 10 years has not been considered. The cash flow analysis yields a small positive NPV of $185K at the end of 10 years. 4.4. Validation of Gate’s projections and Sensitivity Analysis Most of Robert Gate’s projections regarding growth rates over the years seem valid or can’t be commented upon with the given information. However, Gate’s projection of growth rate in selling price per unit of 2% is highly optimistic given that prices have grown at an average of 1.7% over the past 4 years. If the growth rate is changed to 1.7%, the NPV falls down significantly to -$7521K as shown in Figure 4.3.1: Cash Flow and NPV Analysis Figure 4.4.1: Sensitivity Analysis for Selling Price growth rate Figure 4.4.2: Sensitivity Analysis for Discount Factor Figure 4.4.1. Therefore, this factor has a great impact on NPV i.e. NPV is highly sensitive to selling price growth rate. Hence, it needs to be chosen with caution. In addition, the NPV is also highly sensitive to the Discount factor. Even if the discount factor increases marginally to 9.64%, the NPV turns negative as shown in Figure 4.4.2. 5. Key Options & Recommendations Trucker Hanson must consider various options depending upon the planned time horizon. Considering a short term view of 3 years, the investment seems too risky. If the capacity expansion is rendered useless after the 3 year contract, HPL would be able to recover only about $11000K out of the initial investment. However, given a medium term view of 10 years, the proposal seems marginally profitable. Using Dowling’s and Gates’ estimates, the company will break even in the 10th year. However, if there is a significant deviation in the discount factor or selling price per unit, even this would not be possible. Finally, taking a long term view of about 20 years, the facility expansion would last for this period. The company would start reaping benefits of the investments. If qualitative factors such as business generation from other customers, enhanced reputation in the market, economies of scale etc. are considered, this investment can potentially be a blockbuster for the company. Considering both qualitative and quantitative analysis, it can be said that the investment proposal is highly risky for HPL is the short and medium term. Only in the long term with optimistic estimates, the investment yields benefits. Therefore, the proposal must be accepted only if Hanson decides to take such enormous risk. My recommendation would be to try to negotiate a longer term contract with the retailer. If that is not possible, the company should decide to forego the proposal. References McClure Ben. Discounted Cash Flow Analysis. Investopedia-A division of Value Click Inc. Retrieved September 15, 2011 from Read More