You are required to attempt the case study “Working Computers Limited” which accounts for 25% of the
You are required to attempt the case study “Working Computers Limited” which accounts for 25% of the assessment for this unit. The objective of this assignment is to allow you to apply the theories, principles and techniques that you have learned in class to analyse a business situation. The information presented in the case is generally sufficient for you to develop an understanding of the situation. It is important to demonstrate your knowledge of financial concepts and tools in analysing the case.
The assignment may be completed in a group of two or three persons. Please ensure that all names and student numbers of your group appear in the Assignment cover sheet. The following rules will apply to group work:
– Every member in the group is expected to contribute his/her share of the Assignment work in a timely manner.
– Should team conflict issues arise then they need to be resolved prior to submission. You need to remember that you agreed to take on a partner.
– Only in cases where every effort has been made to resolve any problems should the lecturer be asked to intervene.
Working Computers Limited
Please read the adapted case of Working Computers Limited before starting this assignment.
Jennifer Sobieski has taken ill and you are asked to evaluate the capital budgeting decision and consider additional information given below.
1) Preliminary discussions with the bankers of Working Computers led the controller and chief financial officer, Tom LaPonte, to believe that the firm could arrange a 6-year term loan of $18 million for the new investment. The terms of the loan would be payment of yearly interest in advance at a rate of 14% per annum and repayment of the principal owing at maturity.
2) As you were checking the figures provided by Jennifer, you noted that she had not made a provision for the increased sales and production requirements with the new investment. Typically, the provision for accounts receivable, accounts payable and inventory has been about 10% of the annual sales revenue.
3) You had a discussion with Tom LaPonte about the risk inherent in the project of Working Computers and how the company typically adjusts for risk. LaPonte told you that the firm has been adding or subtracting 3 percentage points to its weighted average cost of capital to adjust for differential project risk. When you asked about the basis for the 3-percentage point adjustment, LaPonte stated that it apparently had no basis except the subjective judgement of Peter Smith, a former director of capital budgeting who was no longer with the company. Therefore, perhaps the adjustment should be 2 percentage points or 5 percentage points. Smith also set the acceptable payback period of 3 years for all medium- term projects of Working Computers.
Your task is to prepare the capital budgeting report for the CEO, Stewart Workman, and senior management advising whether the firm should invest more capital in the Bernoulli device or sell the division which has been losing market share. Your report should include the answers to the following Questions 1 to 6. It is important to list your assumptions in applying the investment evaluation techniques, and show clearly the workings in deriving your results. Your assignment will be graded based on presentation, understanding of the issues and logical explanation, and accuracy of calculations in solving the problems. The mark allocations for individual questions (including 20 marks for presentation) will total 125 marks and will be scaled by a factor of 0.2 to produce a mark consistent with 25% weighting in the unit assessment.
1. Given the unit sales information in Table 1, prepare an incremental cash flow table (which incorporate taxes and include initial investment, operating and terminal cash flows) for the Bernoulli division for 2007 through 2012. The incremental approach would consider the cash flows arising from Working Computers investing the $18 million for development of the Bernoulli product at the end of the current year 2006, versus the decision not to invest more capital in Bernoulli. Decide if each of the following items should be included in the cash flow table. Explain your decision.
a) The increase in accounts receivable, accounts payable and inventory with the new investment;
b) The $18 million term loan and the yearly interest expense;
c) Recovery (i.e. depreciation) allowance for the $56 million made in early 2002 and the $18 million new investment;
d) A terminal value for the division at the end of 2012.
Explain clearly your assumptions in deriving the figures in your cash flow.
2. Based on the incremental net cash flows from Question 1, would you recommend to the board of Working Computers to invest the requested $18 million in the Bernoulli based on
(i) the payback period (PP), (ii) net present value (NPV) and (iii) internal rate of return (IRR) methods? Explain why or why not.
3. Given that the CEO had referred to the Bernoulli as a “black hole of creativity and internal funds”, it is crucial that you perform sensitivity analysis on the new investment's NPV before making any recommendation to commit additional funds to revitalise the Bernoulli division.
a) Do a pessimistic sensitivity analysis of NPVs to a change in unit sold and cost of capital. Assume the unit sold could deviate from the estimated quantity by minus 20% and the cost of capital is 3-percentage points higher.
b) Given the competitive nature of the market, Working Computers might have to lower the unit price to achieve the projected unit sales. Determine the value of NPV if Workings would offer a 10% discount on the unit price. How low can the unit price fall before the profit margin would reduce to zero? Assume the cost of goods sold and operating expenses would remain unchanged, i.e. the same percentage of its original unit price.
c) A terminal value in the final forecast year by capitalising the cash flows in that year as the payment from a perpetuity. Do you agree with Jennifer's estimate of the terminal value? Explain why or why not. Consider other alternatives of establishing the terminal value and assess its impact on the NPV.
4. Make a recommendation as to whether or not Working Computers should contribute the requested $18 million to the Bernoulli division. Explain all factors that would affect the decision in your recommendation, including the analysis of the project risk (Question 3) and the potential impact that the requested ongoing investment dollars could have on the plans of Stewart Workman.
5. You expect Stewart Workman to ask about selling the Bernoulli division. What price should Working Computer ask for if it sells Bernoulli today, immediately after making the requested investment? What price could Working Computers expect to receive if it plans to leave Bernoulli alone? [Based your estimate on the unit sales projections given in Table 1.]
6. In addition to the issues in Questions 1 through 5, what other considerations might be appropriate when a firm is considering eliminating a product line or selling a division?
Case in Finance
Working Computers Limited
Jennifer Sobieski, an analyst in the headquarters of Working Computers, has been ask to evaluate whether or not Working should sell a division of the firm which has been losing market share and requires a great deal of new investment to remain competitive. The ailing product is a personal data appliance, or PDA, that once led the market in features and innovation, only to fall prey to competition from numerous firms once it had paved the way for the product category. Complicating Jennifer's analysis and recommendation are several political issues involving the wayward division. In particular, Working's recently returned CEO, Stewart Workman, has decided that the product (the Bernoulli device) is a “loser” and has plan to use the capital currently committed to Bernoulli to boost the ailing performance of other parts of the firm.
Jennifer was struggling with the decision to divest (or perhaps eliminate) a currently profitable product line. Her immediate superior, Tom LaPonte, was the controller and chief financial officer for Working Computers, and had entrusted Jennifer with a super-secret question: could Working do without the Bernoulli division? To be sure, the ultimate decision would be made by LaPonte and the other executives of the firm, including the quixotic and visionary founder and CEO, Stewart Workman. Her task centred on developing the number necessary to portray all relevant aspects of the decision. In addition, she had a feeling that this project was one of special interest to the CEO.
Working Computers had been in business for almost thirty years, and it built and distributed a unique line of desktop computers, laptop computers, and an operating system which was preferred by media professionals around the world. In addition to traditional computers, Working has been one of the first companies to market what had come to be known as a “PDA” or personal data appliance. The research and development expenditure for that product line had come a time when the company is facing stiff competition in the laptop and desktop markets, and millions of dollars had been spent creating a completely new and innovative interface for the Working PDA
– the Bernoulli device. Working's top management, at the time, had felt certain that personal computers were moving in the direction of smaller, more specialised computer which would perform a few tasks more conveniently than a traditional laptop.
THE BERNOULLI DEVICE
The Bernoulli device was a small, handheld device the size of a stenographer's pad with integrated application for recording appointments, addresses and contact information, as well as freeform text notes. It has been design to replace the traditional executive calendar binders. The Bernoulli had been popular due to the ability of users to write new software for the machines. Users had quickly learned that their investment in the Bernoulli gave them the option to program the machines for almost any task, from electronic reference books to data acquisition from industrial machines. Best of all, the Bernoulli would easily interface with a host computer for uploading and printing. The more recent incarnations of the device had been built for accessing internet news services and email servers from the field without the need for a full-size laptop or host computer. For reliability, the Bernoulli had no moving parts.
With success, after a rocky start, came competition. Several different firms had developed PDA which improved on aspects of the Bernoulli, even though the research and development folks at Working had tried to keep the device current Most importantly, competitors sold machines which could be connected to a variety of different computing platforms; the Bernoulli device would only upload and download from a Working-brand computer. In addition, even with Working's head start, competitors had used manufacturers outside of U.S. to lower production costs. To make matter worse, major software developers were beginning to support competing platforms at the expense of the Bernoulli, and that was taking its own toll on market share.
Stewart Workman had recently returned to the firm after nearly ten years heading various other successful and unsuccessful companies. When the board of directors ousted him, he targeted his vision and energy towards developing an understanding of the future of computing. Workman has felt that computers could enhance the life of every consumer. In late 2006, Working Computers had been in trouble and the board of directors decided that Workman might have the ability to “save the firm”. With that in mind, they offered him the position of CEO and chairman of the board. The board granted him an incentive plan that awarded stock options according to the growth of the company's stock price. With that type of encouragement, Workman began asserting his desire for innovation and market leadership, and cast a wary eye toward products and services where the firm was less than dominant.
Workman had already let it be known that he would be outsourcing much of the company's production, based on analyses that Sobieski and LaPonte had put together and backed up with hard numbers from Working's overseas partners. Stewart has also made it clear that the firm would take a different direction, one that stressed leadership in innovation and product design. In keeping with this approach, he had mentioned more than once that the Bernoulli device was “behind the times” and a “drain on the rest of the corporation”. In fact, in one recent executive meeting which included the head of Bernoulli division, Workman had referred to Bernoulli as a “black hole of creativity and internal funds”. The board of directors had allowed Workman to commission research from LaPonte regarding the viability of Bernoulli as ongoing product. In Workman's mind it was clear that the funds that currently went to Bernoulli could be put to use rebuilding the company's market share in desktop and laptop computers. Given the depressed state of the firm's stock price, which was at an all-time low, the board was desperate to find ways of regaining the popularity and reputation that the firm had once enjoyed.
Jennifer had discretely gathered a great deal of information from the Bernoulli unit as well as several of its competitors. In addition, she had spent the greater part of a week downloading information from the internet, mainly opinions of the PDA market and the strengths and weakness of Bernoulli as an ongoing platform.
Jennifer thought that Bernoulli's declining market share was troublesome. In 2006, Bernoulli unit sales had represented approximately 15% of the market, with the largest competitor grabbing
a full 42% of unit sales. Unfortunately, market share had been declining at least one percent each quarter, and there was fear that it would drop even more. This drop was likely due to a large competitor's recent announcement that compatibility with its platform, and not the Bernoulli, would be incorporated into a popular line of office software that was unavailable for Working Computers.
The folks in the Bernoulli labs were currently working on major upgrades to the Bernoulli device as well as the Bernoulli interface software; these improvements would make Bernoulli compatible with almost every personal computer on the market. To continue this research, the Bernoulli division estimated that it would need no less than $18 million in the next month in order to finish the development of the more advanced product. Allocating this investment within the division was the responsibility of the division's operating officer, and Jennifer was confident that the money would be put to good use. When the new product become available in late 2007, it was likely that Bernoulli could regain as much as 8% of the market within the first year, with gain of 4% per year after that. Nonetheless, in recent meetings, Stewart Workman had criticised the $18 million request as being “insane” stating that he knew of several places in the company where those funds could “earn at least our normal cost of capital for the shareholders”. The company would have to borrow externally for this type of investment, and is not an issue given its history of good credit rating. Jennifer had forecasted unit sales for the period 2007 through 2012 (Table 1), and she had calculated demand both with and without the additional market share that the new product was expected to generate.
TABLE 1: Unit Sales Projections
Periods ending 31 December 2006 through 31 December 2012 (units, in thousands)
with new investment
Unit Sold, without new investment
Currently, the Bernoulli division operated with a cost of goods sold of approximately 60% of the unit price and operating expenses (excluding depreciation) averaging 24% of total revenues. With declining market share, the division expected to sell a total of 1,200,000 units by the end of 2007 at a price of $395 each. The new model expected to ship beginning in late 2007 would sell at the same price point. The division's manager estimated the revised Bernoulli would have a cost of goods sold of 54% of the retail price with higher operating expenses of 26% due to increased advertising. These cost estimates were expected to remain the same for the next several years. On the other hand, the price point and unit sales could be higher or lower depending on the market demand and any actions taken by competitors. Given the competitive nature of the industry, the unit sales projection for the new device could deviate from the estimated units given in Table 1 by plus or minus 20%.
For strategic planning purposes, Working's management allocated depreciation to the existing Bernoulli division as though the entire division was an asset in the modified accelerated cost recovery (MARCS) 10-year asset, with five years of operation behind it. The initial investment of $56 million had been made in early 2002. Recovery allowance percentage according to MARCS are shown in Table 2. The new funds allocated to the division would be treated similarly except that management had decided any new investment would be depreciated using the MARCS category for 5-year assets. Due to changes in the industry since 2002, this is expected to be more consistent with the nature of the market for computing devices and PDAs. Working's managers used a weighted average cost of capital of 18% when evaluating capital budgeting projects, and Jennifer felt that this would be an appropriate discount rate in this instance as well. The firm's marginal tax rate, for planning purposes, was 30%.
TABLE 2: Depreciation Schedule
Modified Accelerated Cost Recovery (MACRS) Allowance Percentages*
* Note that the yearly percentage is applied to the initial cost of the asset.
Finally, Jennifer had to consider the fact that the company always held the option to sell the Bernoulli division to an existing competitor. In fact, there were rumours on the internet that several quiet and unofficial offers had already been discussed with the members of the board of directors. In developing her analysis, Jennifer would have to come up with an estimate of a price for the division, based on the sales and market share expectations she had gathered. To establish a terminal value in the final forecast year, 2012, she would capitalise the cash flows in that year by dividing them by Working's overall cost of capital, essentially treating that year's cash as the payment from perpetuity. In the event that management declined to invest the requested $18 million today, the Bernoulli division could still maintain some level of sales for several years, and the patents held by the division would be worth selling or licensing as well.
For her previous presentation to senior management, Jennifer produced detailed discounted cash flow analyses accompanied by documents to support her assumptions. In addition, she usually spent some time developing sensitivity analyses using any numbers that she expected to be questioned by the board. This time her main fear was that her understanding of the growth in market share, because the revised Bernoulli due in late 2007, would turn out to be optimistic.