Alfahome Plc is a company making a range of popular household liquid cleaning pr
ID: 2541526 • Letter: A
Question
Alfahome Plc is a company making a range of popular household liquid cleaning products. It has a loyal customer base as customers tend to use the same products for many years. Alfahome Plc’s target return on investment is 15% per annum. The company replaces assets regularly to keep them up to date.
The company regularly produces a 6 year plan. The plan for the six years is shown below:
Alfahome Plc has a range of products in regular demand and a few more fashionable products with life cycles. One of its products is expected to peak in 2019 and then begin to decline, so a new, fashionable product ‘Mega Wash’ with a potentially short life is being developed.
Although production of ‘Mega Wash’ will mostly use current available capacity, new machinery costing £72 million will be needed. This will be bought in at the beginning of 2019 and depreciated straight line over four years. The products are sold in cartons of 10 bottles.
In addition to the new machine, the table below shows the forecast cost and revenue cashflows (note 1) for Alfahome:
Fixed costs (note 3) ($M)
Notes
1. The cashflows shown in this table can also be regarded as accrual based costs and revenues for each year.
2. Research and development cost are written off in the year incurred.
3. It is expected that variable production, variable marketing, and product fixed costs will increase by 4% each year.
Price, marketing cost and market demand are the amounts estimated by the marketing department.
Required:
(a) Calculate the residual income of the company for each year of the forecast, before consideration of the new product.
(b) Calculate and present on a year by year basis, the ‘Mega Wash’ lifecycle and calculate the residual income of the ‘Mega Wash’ for each year of its life and the total residual income for the company as a whole for each year of the six year forecast.
(c) Calculate the Net Present Value of the ‘Mega Wash’ Lifecycle. Using 15% cost of capital:
(d) Comment on the viability of proceeding with the ‘Mega Wash’ and its effect on the yearly residual income target.
(e) Discuss how the information provided by the calculations in parts a–c can be used in the future strategic decisions of the company.
Year Net income ($M) End of year Net Assets ($M) 2017 75 400 2018 80 400 2019 75 400 2020 65 400 2021 70 400 2022 40 400Explanation / Answer
1. Residual Income of the company for each year of the forecast, before
consideration of the new product
Residual income = Net income -(Average assets x minimum required rate of return)
Minimum required rate of return =15%
Average Assets = $400m as it is same over the period of 6 years
Year
Net Income ($M)
Average Assets ($M)
ROI
Return on Assets
Residual Income (NI -ROA)
2017
75
400
15%
60
15
2018
80
400
15%
60
20
2019
75
400
15%
60
15
2020
65
400
15%
60
5
2021
70
400
15%
60
10
2022
40
400
15%
60
-20
NI = Net Income
ROA = Return on Assets
2. "Mega Wash" lifecycle and residual income
2018
2019
2020
2021
2022
Price per carton ($)
30
28
25
20
Estimated Market Demand (Cartons)
2000000
5000000
6000000
4500000
Variable Production costs per carton ($)
6
6.24
6.49
6.75
Variable Marketing Costs per carton ($)
2
2.08
2.16
2.25
Sales Revenue
60000000
140000000
150000000
90000000
Variable Production costs ($)
12000000
31200000
38937600
30371328
Variable Marketing Costs ($)
4000000
10400000
12979200
10123776
Contribution Margin
44000000
98400000
98083200
49504896
Less:
Fixed Cost
15000000
15600000
16224000
16872960
Marketing
4000000
12000000
6000000
8000000
4000000
Research and Development costs
6000000
4000000
Net Profit
(10,000,000)
13,000,000
76,800,000
73,859,200
28,631,936
Assets at the beginning
72000000
54000000
36000000
18000000
Assets at the end
54000000
36000000
18000000
0
Average Assets
63000000
45000000
27000000
9000000
ROI
15%
15%
15%
15%
15%
Return on assets
0
9450000
6750000
4050000
1350000
Residual Income
(10,000,000)
3,550,000
70,050,000
69,809,200
27,281,936
Total Residual income for the company as a whole for each year of six year forecast
Year
Residual Income (NI -ROA)($M)
Residual Income for Mega Wash ($M)
Residual income for the company as a whole
2017
15
15
2018
20
-10
10
2019
15
3.5
18.5
2020
5
70
75
2021
10
70
80
2022
-20
27
7
3. Net Present value of the "Mega wash" Lifecycle
2018
2019
2020
2021
2022
Machinery Cost
(72,000,000)
Net Profit
(10,000,000)
13,000,000
76,800,000
73,859,200
28,631,936
PV Factor
1
0.87
0.756
0.658
0.572
Net Present Value
(10,000,000)
(51,330,000)
58,060,800
48,599,354
16,377,467
NPV Total
61,707,621
Cost of machinery is cash outflow in 2019
4. The project of "Mega Wash" with a short life of 4 years is viable as its NPV is positive and it will
increase the residual income for the company as a whole. In 2022 as per the six year forecast, residual income
will be negative but if they will start this project, residual income will be positive.
5. In future strategic decisions, company can use the information about the residual income forecast
for the next six years, and also it can compare new product with Mega wash net income, residual value
and net present value.
1. Residual Income of the company for each year of the forecast, before
consideration of the new product
Residual income = Net income -(Average assets x minimum required rate of return)
Minimum required rate of return =15%
Average Assets = $400m as it is same over the period of 6 years
Year
Net Income ($M)
Average Assets ($M)
ROI
Return on Assets
Residual Income (NI -ROA)
2017
75
400
15%
60
15
2018
80
400
15%
60
20
2019
75
400
15%
60
15
2020
65
400
15%
60
5
2021
70
400
15%
60
10
2022
40
400
15%
60
-20
NI = Net Income
ROA = Return on Assets
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