INTRODUCTION

 

Dixie Corporation is an Australian Company and mainly relies on imports for doing business however; the company has an option to produce its own products. The decision whether to import or produce itself is a capital budgeting decision. Not only this, it is also a matter of concern that if Dixies decides to produce how much it should produce? Whether it should produce both product A and B? In which proportion should Dixies produce A and B? How sensitive is the project to changing interest rates or expected growth of the products? What if the initial investment changes and how the change in initial investment will impact the overall decision of the product manufacturing?

 

The current study digs out answer of all questions through capital budgeting method of NPV. The report also analyses the sensitivity of the project by using risk modelling and Monte Carlo simulation.  A few recommendations have also been provided on the basis of calculations and analysis that what decisions should Dixie takes in order to maximize its business potential.

Problem Description

 

The key question under analysis is whether Dixie should import or it should produce the products? There are two products i.e., Product A and Product B. Product A is of superior quality product whereas Product B is inferior quality product. Demand for product B is on decline whereas A has strong market demand. Following problems are currently being faced by Dixie Corporation with respect to production of Product A and Product B.

1. Should the company start in-house manufacturing or keep importing the products?
2. If company decides to produce, which product it should produce on priority?
3. How risky is the venture and what is the probability of negative NPV?

 

Business Assumptions

 

Several facts and figures are available to Dixies Limited, few of which are mentioned below:

1. The capital investment required for the project is $331,870. The equipment will depreciate on straight lint method and will depreciation completely in 06 years.
2. Annual growth for product A is on increasing trend i-e. 10% per annum whereas demand for product B is on declining trend i-e 15% per annum. Product A also has higher price i-e $1,315 as compared to B.
3. Fixed cost will increase with a rate of 1% per annum however; variable cost will remain constant i-e. 110 per unit.
4. Tax rate is 30% for Dixie Corporation and any negative tax will be considered as profit by the company.
5. The internal rate of return for the company is 12%.
6. Total capacity of the

Objective of Solving the Problem

 

The stud is aimed to identify the optimal solution for Dixie whether it should produce the product A and B or not. The risk analysis will guide the company about overall riskiness of the project. Not only this, sensitivity and what if analysis will help company to identify the potential rate at which company should obtained loaning (discount rate) or attain annual growth rate of product A through its marketing function. Also which is more desirable zone in which capital investment should lie in order to make the project most profitable.

MODEL FORMULATION AND OUTPUT ANALYSIS

 

The study uses Capital Budgeting technique of Net Present Value to identify how profitable the project is. A project is acceptable if its net present value is positive. Net present value is sum of all future cash flows discounted on desired rate of return. A zero negative present value means that a project will not yield anything extra for the business however, will be able to meet its desired rate of return.  Any project with positive NPV is highly desirable with respect to capital budgeting notion (Needles, Powers and Crosson, 2010). The NPV model is formulated on the basis of cash flow of the project instead of net income as the net income derived from the project may not reflect the true position of the project. Cash flow from a specific project reflects a more comprehensive position of the revenue and cash expenses of a specific project (Smith, 2002).

Basic NPV Model

Product A has higher demand as compared to B. As well as it has higher profit margin as compared to product B, therefore, the preference is given to A. maximum capacity is assigned to A whereas the rest of capacity is assigned to B. If demand of A exceeds the total capacity, only A will be produced up to an extent of total capacity.

1.      The Model and the Outcome

 

Assuming that company produces both A and B with respect to capacity and by keeping all the underlying assumptions in view, the NPV is calculated below.

 

Table 1: Calculation of NPV

Year	0	1	2	3	4	5	6
Capacity		7,500	7,725	8,000	8,000	8,000	8,000
Production of Type A Units		5,400	5,940	6,534	7,187	7,906	8,000
Production of Type B Units		2,100	1,785	1,466	813	94	–
Total Revenue		9,747,000	10,060,200	10,439,370	10,475,307	10,514,838	10,520,000
Variable Cost		8,250,000	8,497,500	8,800,000	8,800,000	8,800,000	8,800,000
Gross Profit		1,497,000	1,562,700	1,639,370	1,675,307	1,714,838	1,720,000
Fixed Cost		1,300,000	1,313,000	1,326,130	1,339,391	1,352,785	1,366,313
Operating profit before Tax		197,000	249,700	313,240	335,916	362,052	353,687
Tax @30%		59,100	74,910	93,972	100,775	108,616	106,106
Operating Cash Flow		137,900	174,790	219,268	235,141	253,437	247,581
Depreciation Tax Saving		16,594	16,594	16,594	16,594	16,594	16,594
Net Cash Flow	($331,870)	154,494	191,383	235,862	251,734	270,030	264,174
PV of Cash Flows	($331,870)	137,941	152,570	167,882	159,982	153,222	133,839
Net Present Value		$573,565

 

2.      Outcome of Model

 

The NPV of the project is $573,565 which implies that it is profitable for Dixies to produce both product A and Product B while keeping A on priority. After taking the effect of depreciation tax savings, the net cash flows of the project is positive. Net present value of all cash flows is positive which implies that the project is worth undertaking. The company should start its own manufacturing instead of importing the goods from abroad.

 

What-If Model

 

If the company produces both A and B, the NPV will be $573,565. Now the question arises if the company entirely focus on production of A and eliminates the production of B, will the NPV increase? This requires an analysis of NPV by eliminating the production of B. keeping all other assumptions constant, the NPV is calculated for the project if company completely focuses on production of A and eliminated the production of B.

 

Table 2: NPV when Production of B is Zero

Year	0	1	2	3	4	5	6
Capacity		5,400	5,940	8,000	8,000	8,000	8,000
Production of Type A Units		5,400	5,940	6,534	7,187	7,906	8,000
Production of Type B Units		–	–	–	–	–	–
Total Revenue		7,101,000	7,811,100	8,592,210	9,451,431	10,396,574	10,520,000
Variable Cost		5,940,000	6,534,000	7,187,400	7,906,140	8,696,754	8,800,000
Gross Profit		1,161,000	1,277,100	1,404,810	1,545,291	1,699,820	1,720,000
Fixed Cost		1,300,000	1,313,000	1,326,130	1,339,391	1,352,785	1,366,313
Operating profit before Tax		(139,000)	(35,900)	78,680	205,900	347,035	353,687
Tax @30%		(41,700)	(10,770)	23,604	61,770	104,110	106,106
Operating Cash Flow		(97,300)	(25,130)	55,076	144,130	242,924	247,581
Depreciation Tax Saving		15,094	15,094	15,094	15,094	15,094	15,094
Net Cash Flow	($301,870)	(82,207)	(10,037)	70,170	159,223	258,018	262,674
PV of Cash Flows	($301,870)	(73,399)	(8,001)	49,945	101,189	146,406	133,079
Net Present Value		$47,350

 

 

If Dixies only produces A, the NPB will be $47,350 which is less than the situation when the company was producing both A and B. this is due to the fact that higher production by company generates more revenues for the company and help company to cover the fixed cost. Also the capacity is not under- utilized and if company is operated at full capacity, it will yield a higher NPV than otherwise.

Goal-Seek Model

 

Another situation to ponder is that if company manages to reduce its initial capital investment, will that be beneficial for the company in terms of NPV. If Dixies do not product B and only produces A, at which level of initial investment will NPV will be equal to $573,565? Through Goal Seek function, the same can be identified.

 

CALCULATION OF INITIAL INVESTMENT WHICH MAKE 2ND CHOICE  NPV EQUAL TO FIRST CHOICE
Project  A NPV				573,565
Project B NPV				$47,350
Value of Initial Investment at which B= A				224,345
Checking the Goal Seek Function Result
(Replacing the initial investment of (301,870) of B project Cash flows with the answer calculated by Goal Seek)
			0			1		2		3		4			5		6
PV of Cash Flows of project where B is abandoned			224,345			(73,399)		(8,001)		49,945		101,189			146,406		133,079
NPV			573,565

 

RISK MODELLING AND ANALYSIS

Risk Measurement and Assessment

There are several risks that can change the project outcome. It is always possible that government increases the discount rate as it is an external factor and therefore, Dixies cannot control it. On the other hand, it is also possible that annual growth of demand of A does not attain the desirable figure i-e 10%.  Dixies cannot control the currency exchange rate so there is always a chance that initial capital investment increases due to currency fluctuation. The variables can act against as well as in favour or Dixies and therefore, a careful analysis is required. It is important to know how flexible the project it and up to which extent the project remains favourable.

Optimistic & Pessimistic Models And Their Implications

 

Two models have been developed based on the assumptions that discount rate, capital investment and annual growth rate of A does not behave as anticipated. They can move in favour of Dixies or against the company. A pessimistic and an optimistic model have been developed in order to analyse up to which extent the NPV can increase or drop. Since capital investment has a mean of $960,000 for all other similar projects, therefore, the optimistic and pessimistic model is developed using the mean capital investment.