The FieldFlower case

The FieldFlowerCorporationMatthew Banks has been asked to conduct an investment appraisal and present it to the board of directors at the FieldFlower corporation: a fairlylarge company manufacturing gardening equipment. The company is privately owned and with strong market positions in the Scandinavian region. The company is profitable and receives substantial positive cash flows from operations. So far, FieldFlower has targeted the professional market (garden centers, janitorsand larger housing communities). One year ago, the owner decided to investigate whether FieldFlower should focus on the private market. Although the products in this market serve essentially the same purpose, there is a considerable need for well-designed products. In addition, the company does not currently have maintained distribution channels.Matthew has a finance degreeand someknowledge of the current operations. His job is to make some sense to this investment decisionand present it to the board. He has no experience of marketing/sales, but he has consulted a senior sales officer and relies on his sales forecasts. Thanks to Matthews previous work tasks, hehas a good understanding of production at FieldFlower. Underneath, you find information Matthew has compiled and will present to the board of directors.Unless stated differently,numbers are in millionsof Euro.Normally, FieldFlower assumes that the investment horizon is ten years, but in this case the board of directors has determined to reduce it to only six yearswith the argument that “…it will significantly reduce the risk of the project”.Already today the existing manufacturing facility works on full capacity. FieldFlower has increased its work force with 5% during the last year and any new investment will require additional hirings (included in the estimated costs underneath).The expansion towards the private market segment will require FieldFlower to invest in a new facility. Fortunately, the company owns property in the direct vicinity of the current manufacturing site. Matthew expects that this can reduce the cost of the initialinvestment substantially. He estimates that new initial investments to be 7million, and in addition, external services for 2 million needs to be acquired. Matthewis expecting that current employees (mainly senior officers such as engineers) will have to put in 1600 hours of work(equivalent of one year oflabor).It is expected that the start-up time is 8-10 months.The economic life of the investment is longer than six years. For this reason, Matthew expects its value to be 3,4 million at the end of year six. Tax authorities require FieldFlower to write the initial investment off over nine (9) yearsusing a straight-line depreciation planwhere the salvage (orterminal) valueis set to nil(0).As said, the project is based on the idea of using properties already owned by the FieldFlower corporation. However, this property is currently rented out to another company. FieldFlower owns the property, but the contract covers anothersix yearsand provides FieldFlower revenues of 90 thousand. The contract has a clause that allows FieldFlower to immediately cancel the contractfor 60 thousand. If the property is sold, its market value is 800 thousand, a value that is likely to be stable for the next six years. Matthew has, however, not heard that the property is goingto be sold. The property has a book value of 300 thousand and annual depreciation costs of 60 thousand.Immediately following the initial investment, there will be a need for working capital (purchase of raw materials and other input goods, inventory build-up and credits to customers). Matthewhas assumed that the working capital need is 2,0 million, but the sales manager has said thatsuch capital needs are often underestimated and that customers might need additional credits to accepta need supplier such as
FieldFlower. Matthew foresees additional capital needs of 2,0 million at the beginning of the third year. All investments in working capital are expected to be fully recovered by the end of year six.Quite obviously, the most important and difficult forecast to make concernsthe cash flow generated from selling products.FieldFlower is currently a rather unknown brand and the launch of its new product series will require substantial marketing and rebates to distributors. The senior sales officer suggests large extraordinary marketing and sales activities in the first year that will cost 5,0 million. This entire amount is tax deductible.The sales officer has forecasted sales volume and prices (including rebates). Matthew compiles this information with his own estimates of production costs and derivesan expected EBITDA1(EarningsbeforeInterest, Taxes, Depreciationand Amortization)including ordinary market activities, employee costs and other costs. The EBITA profit measureis equivalent to an operating cash flow (it excludes the depreciation).Year 1Year 2Year 3Year 4Year 5Year 62,02,04,74,74,76,0The main owner of FieldFlower requires all projects to return at least 12%. The expected tax rate for the coming six years is 22%.Exercises and discussion questions1.Identify the relevant cash flows and use Excel to map them out.-Are there cash flows you should not consider? Explain your thoughts.2.What investment proposal should Matthew present to the board of directors? Base the decision on the net present value (NPV) and payback model techniques.3. Assess the project’s internal rate of return.4. Theboard of directors finds the risk with this project to be relatively large as it both affects FieldFlower’s long-term strategy and it has large monetary consequences. For this reason,it decided to shorten the project’s economic life to six years. -Discuss whether this is a good way to deal with the risk?5. A perhaps technically difficult calculation concerns how to deal with the facility in which production will occur (and is currently rented out). Explain how to treat the facility in an investment analysis.6. A sensitivity analysis is always desirable. Are there aspects (strategic and/or technical) that you think Matthew should have considered in his analysis?7. At the lunch before the board of directors meeting, Matthew talks to the head of the accounting department who introduced Matthew to the fascinating world of financial accounting. The manager from the accounting department claimed that cash flows can be moved between accounting periods. Forexample, parts of the initial investment can be expensed immediately (in year 0 and thus have tax consequences in year 1).Matthew had little knowledge of accounting, but perhaps it would be a wise idea to capitalize cash outflowsas investments in assets and delaytheir expenditure to subsequent time periods. -Would that be beneficial for the project’s profitability?