Please read the following Scenario: Elisa McRay was recently hired as cost analy

Question

Please read the following Scenario:

Elisa McRay was recently hired as cost analyst by Medlab Medical Supplies Inc. One of Elisa's first assignments was to perform a Net Present Value analysis for a new warehouse. Elisa performed the analysis and calculated a Present Value Index of 0.75 the plant manager, Mark, is very intent in purchasing the warehouse because he believes that more storage space is needed. Mark asks Elisa into his office and the following conversation takes place:

Mark: Elisa, you are new here aren't you?

Elisa: Yes, sir.

Mark: Well, Elisa, let me tell you something. I'm not at all pleased with the capital investment analysis that you performed in these new warehouse. I need that warehouse for my production. If I don't get it, where are am I going to place our output?

Elisa: Hopefully with the customer, sir.

Mark: Now don't get smart with me.

Elisa: No, really, I was being serious. My analysis does not support constructing a new warehouse. The numbers don't lie, the warehouse does not meet our investment return targets. In fact, it seems to me that purchasing a warehouse does not add much value to the business. We need to be producing product to satisfy customer orders, not to fill a warehouse.

Mark: Listen, you need to understand something. The headquarters people will not allow me to build the warehouse if the numbers don't add up. You know as well as I that many assumptions go into your Net Present Value Analysis. Why don't you relax some of your assumptions so that the financial savings will offset the cost?

Elisa: I'm willing to discus my assumptions with you. Maybe I overlooked something.

Mark: Good. Here is what I want you to do. I see in your analysis that you don't project greater sales as a result of the warehouse. It seems to me, if we can store more goods, then we will be able to manufacture more goods, which will mean we will have more to sell. Thus, logically a larger warehouse translate into more sales. If you incorporate this into your analysis, I think you will see that the numbers will workout. Why don't you work it through and come back with a new analysis. I am really counting on you on this one. Let's get off to a good start together and see if we can get this project accepted.

Please make sure that within your text you mention in detail:

1. What is your advise to Elisa? Why? (Please elaborate)

2. Is Mark correct on his assumption that a large warehouse will bring more sales? Why or Why not?

3. What will happen for each accounting period when production is increased but stored not sold? Describe the effect in the balance sheet and the income statement for the excess production period and the sales period. Hint, the accounts you want to look at are: Inventory, Cost of Goods Sold, Depreciation Expense.

Explanation / Answer

Solution:

1.Advise to Elisa:

As provided that Elisa has calculated Present value index which is less than 1 i.e. .75 that showas that the project is not feasible. Before making any investment, investment evalution must be done. Economic evalution of a project is carried out by investment evaluation methodthat include:

a) Net Present Value :-NPV is the investment evaluation method that accesses the profitability of a proposed investment.Its purpose is to estimate whether the present value of future cash flows exceeds the initial investment.

b) Internal Rate of Return :-IRR is widely used method infinance and it is clearly related to NPV. IRR is defined s the rate of discount at which a project would have zero NPV. IRR reflects the rate of return a project earns.

c) Payback :- The Payback is commonly used traditional method in evaluating of investment opportunities. It is designed to estimate the length and time to recover the initial investment.

d) Pay off:- Pay off is called the discounted payback period method that takes into account the time value of money. This approac is similar to the traditional approach pay back period, but when calculating the payback period, the discounted cashflows are applied.

2. No, Mark is not completely correct in his assumption as for more sales other factors should also be considered. These factors are as follows:-

a) External Demand: Sales depends on market demand. If there is no extra demand than no extra sales could be made.

b) Sustainablity of Goods:- If goods are of the non durable nature than also it is not advisable to construct warehose.

c) Nature of Goods:- Demand also depends on the nature of goods. If goods are of daily use demand could be increased but for luxirious goods demand would be slightly change only.

A high production doesn't always gurantee high sales for that demand and supply analysis shouls be done otherwise negative impact would be seen.

3.Effect of Excess productiom on Balance sheet and Income Statement

i. The closing inventory in the balance sheet would be in a high amount for that period.

ii. Cost of Goods sold would decreases which also impacted the gross profit for that period.

iii. Cost of production would be increased which result in low gorss profit.

iv. A high amount of inventory will show lying in the balance sheet.

v. A high production decreases the efficiency of the machines. Thus decreases the life of machine.

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