1. Report on the viability of Envchem’s new product.
1.1. Decision trees: Calculating sales volume
We will calculate expected first year sales in litres per month based on the probability of positive and negative outcomes, and building our projections around a decision tree. Chance events are continuous, and include average monthly sales of 110,000, 100,000, 90,000, and 80,000 litres.
110,000 * 25% = 27,500
100,000* 40% = 40,000
90,000 * 25%= 22,500
80,000 * 10% = 8,000
Summing it up, 27,500 + 40,000 + 22,500 +8,000= 98,000 litres
If a rival company, Dawes Detergents, develops and launches its competing product first, there is a probability that the sales will be reduced by half, that is, will go down to 49,000 from 98,000 litres. The chance events in this case are discrete: the first event is the entry of the competitor; the second is the situation when Envchem is alone in the market.
There is a 30% chance that the rival product is launched. Its impact will be reflected as follows. Using the decision tree once again, the sales will total 49,000*30% + 98,000*70% = 14,700 + 68,600 = 83,300.
The sales in the subsequent years that are expected to total 125,000 litres a month are also expected to be reduced by half if Dawes Detergents gets in the market first, that is, will total 62,500 litres a month.
Calculating the probability of this event, 125,000*70% + 62,500*30% = 87,500 + 18,750=106,250. Thus, in the second and subsequent years, the company can expect to sell 106,250 litres per month.
Thus, the forecast for the first-year sales is 62,500 litres a month, for the years 2-10 106,250 litres per month. To see whether the managers need to go ahead with the plan, we will have to test the viability of the new detergent, namely, to find out whether the company will be able to make a profit through this launch. In the analysis, one will need to consider the following factors: sales revenue from the product, variable costs, and mark-up on variable costs. It is assumed that fixed costs other than factory depreciation are irrelevant since no information is provided in the case. Among fixed costs, marketing costs are believed to be irrelevant to the probability of sales levels, as the public opinion of the product is independent of the marketing campaign.
1.2. Sensitivity analysis: Dependence on price level
Using the sensitivity analysis, we will look at how the profit is going to change in different scenarios based on three different prices of ?1.50, ?2 or ?2.50 per litre. We will first examine what will happen in the first year.
If the price is set at 1.50, the annual revenue will total 83,300 * 12* 1.50 = 1,499,400 in the first year.
If the price is set at 2, the first-year annual revenue will total 83,300 * 12* 2 = 1,999,200.
If the price is set at 2.5, the first-year annual revenue will total 83,300 * 12* 2.5 = 2,499,000.
In the second year, the revenue is going to be
In Scenario 1 (J1.5 price): 106,250 * 12*1.5 = 1,912,500
In Scenario 2 (J2 price): 106,250 * 12 * 2 = 2,550,000
In Scenario 3 (J2 price): 106,250 * 12 * 2.5 = 3,187,500
1.3. Breakeven analysis
Using breakeven analysis, we will nor try to calculate how much the company needs to sell to at least break even on its costs. To do this, we will need to compute the annual depreciation.
The factory is expected to cost J10,000,000 and have a scrap value of 5% after ten years. Thus, if one assumes straight-line depreciation, the annual depreciation amount is as follows:
(10,000,000 – 10,000,000 * 5%)/10 = 950,000
To complete our calculation of fixed costs, we need to factor in the reduction in profits that will result from the moves of its two technical employees and total ?50,000.
Thus, the fixed costs are going to total 950,000 + 50,000 = 1,000,000.
As the mark-up on variable costs is 60%, if the company breaks even, the variable costs will total 1,000,000: 0.6 = 1,666,667
The company needs to generate the following amount of revenue to break even:
1,666,667 + 1,000,000 = 2,666,667
1.4. Testing the viability of Envichem’s products
Looking at the numbers obtained in the breakeven analysis, we can conclude that Envichem is going to break even only if the price is set at J2.5 per litre or above, as the revenue exceeds the required J2,666,667 level in the second and subsequent years. True, the company will fall short of the expected level in the first year, with only J2,499,000 in annual revenue. However, the loss of 2,666,667- 2,499,000 = J167,667 will be offset by the profit of 3,187,500 – 2,666,667 = 520,833 in all subsequent years. As the loss in the first year is offset by profits in the subsequent years, the managers of Envchem have to go ahead with the product.
The analysis is based on the assumption that Envichem will be able to sell the factory after 10 years of service and realize the scrap value, although this estimated value may not always be realizable.
Decision tree analysis was based on the numbers that were generated by the marketing department, and they probably used in their estimates the current state of the industry. It is extremely hard to make projections over a lengthy period of time, and this may be a limitation to the analysis as presented here.
Besides, the decision tree as presented here only allows for four variants of cash flows, and any other possibilities are not taken into account. The average expected sales volume obtained from the decision tree is only an approximate measure for computations.
Breakeven analysis also has some limitations. It fails to take into account the alternative use of the funds, such as leasing the company’s premises. Besides, this analysis does not account for cash flows and is grounded in the profit as it is recognized by accoountants (CBSCs). This analysis makes assumptions that the relationship between cost and revenue is constant, and that relationships such as the mark-up on costs remains static.
Sensitivity analysis is based on changes in one key variable, in this case the price. The analysis is based on the assumption that all other variables remain intact which may not always be the case. It makes sense to analyze the case from the viewpoint of what might happen if several variables change. The analysts would also do well to examine the relationship between the key variables. For example, if the production volume rises or drops, the mark-up on variable costs might change. The above-mentioned analysis presumes that this markup is kept steady.
The analysis rests on the assumption that the investment is depreciated on a straight-line basis, that is, the value of the factory is lost in equal amounts year after year. This may not be the case as many investments lose value most quickly in the first years, and later are in fact depreciating more slowly. One would be forced to arrive at this conclusion if value is estimated based on sales price that can be obtained if the asset is disposed of.
2. Explain how an understanding of the ‘principal-agent’ problem might be useful in a decision problem of this kind.
Principal-agent problem refers to the asymmetry of information that arises when one party performs the work for another party. Thus, when one hires an employee to perform a certain task, one has no safeguard against the employee’s dishonesty. The principal-agent problem usually surfaces when a corporation hires top managers to handle its management. Then the temptation for the manager is great to misuse the trust of the corporation’s owners and to abuse powers to manage the affairs of the business to suit one’s own interests. This may result in «divorce between ownership and control» (Tutor2u).
Companies have tried to ward off this problem by establishing efficiency wages, paying commissions based on the performance of the corporation, and introducing profit sharing schemes (Wilkipedia). Alternatively, the employment contract may be «bonded», that is, it may stipulate that the management may be removed if the company fails to meet certain expectations (Absolute Astronomy).
Overall, the principal – agent theory posits that a principal will most efficiently act through the agents. That is why the principal hires agents that will help the principal to perform the work. Then the problem arises of controlling these agents and devising the incentives for them to act in accordance with the principal’s interests. If the principal fails to invent a scheme that will motivate the agents accordingly, the agents will be tempted to act in their own interest rather than the agent’s (About.com).
The principal-agent problem can be applied here in two ways. First, it may be used to evaluate the motivation of Envchem’s management in putting the product on the market. We can question whether the managers are acting in the shareholders’ best interests. Shareholders are obviously interested in projects that add long-term value for the company if they expect to hold this stock for a while, whereas managers can strive to make a quick profit and then step back after pocketing sizable sums in compensation, such as rewards and bonuses based on the company’s performance in the given year. One of the greatest problems with the current executive compensation schemes is that bonuses are awarded based on current results, and stock compensation is often used as a way to make money through inflation of the stock price. Managers are seldom rewarded for long-term results.
In the case with Envchem’s Emerald, analysts cannot be sure that the product is indeed going to generate profits and adequate revenue in the long haul. They may be tempted to launch a product that is bound to sell well in the short term, while incurring development costs that boost initial outlays too much in comparison with the expected profits. A wrong investment decision may lure the company’s resources such as technical staff from other projects that can be predicted to generate better long-term value for Envchem’s business.
Envchem can supply business analysts of CapFinance Ltd. with incorrect information, thus offering them false grounds for their calculations. In a broader sense, Envchem can be seen as an agent for CapFinance Ltd. Finance companies have the funds but do not have the expertise or skills needed in order to invest these funds in the creation of real assets, thus, in manufacturing. Instead, finance companies lend their money to other entities that are able to use them in manufacturing projects. Financiers then charge a fee for using their money in the form of an interest rate for the loan. Thus, the relationship is similar to the situation that would exist if finance companies hired manufacturing companies to do the job for them for a certain fee. Manufacturers, however, may have their own interests to pursue, and the timely return of the loan may not be on the priority list. They may use false information to secure a loan. Executives may be hard pressed to do this, if they, for example, are urgently seeking for funds to cover up an accoounting scandal. Or, as mentioned before, they may be seeking to maximize short-term profit and thus look for a loan that will help them to implement this task.
It will be rather difficult for CapFinance Ltd to control Envchem if they lend them the money. They cannot very well replicate the incentive system applied by shareholders to their management as Envchem is not their subsidiary and its staff are not CapFinance’s employees.
3. Advice on the loan request.
The loan request has to be approved or declined based on a realistic estimation of the product’s viability. There are two factors to consider. First, analysts of CapFinance Ltd are to perform a detailed analysis of Emerald’s viability as presented in part 1.
Second, they have to look beyond the numbers and test the assumptions behind the analysis. If these assumptions are found to be false, analysts might want to question the validity of their conclusions. It is worthwhile to examine the prospects of the industry as a whole and products in Emerald’s class in particular. If the future bodes well for environmentally friendly detergents, CapFinance Ltd might want to invest in this booming business. On the contrary, if the market seems to be overcrowded, CapFinance Ltd could look for some other place to invest money.
CapFinance Ltd needs to be aware of the overall financial health of Envchem. One place to obtain such information is the credit ratings agencies that assess the company’s creditworthiness based on the information found in its financial statements. Alternatively, financial analysts might choose to do this work on their own. They will need to examine the long-term assets of the company and compare them with the liabilities to see if the company can be expected to hold its long-term obligations.
CapFinance needs to look at the business practices of Envchem, probably testing due diligence of its executives. Sound management practices are essential for the company that takes out a loan, as problems with management can jeopardize CapFinance’s chances of recovering the loan amount. For example, if company managers are engaged in fraudulent activities, CapFinance had better try to clarify this at once.
CapFinance needs to assess the risk associated with the loan to Envchem and try to assess the rate of return they would like to have to compensate them for the risk. Then they will need to juxtapose this rate with the return on investment Envchem is supposed to be able to get from its Emerald product. If Emerald, for example, makes 5% off its investment, and CapFinance will charge no less than 7%, then the loan does not make sense.
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Explanation of Sensitivity Analysis:
We take all the factors to be the same except the price, and calculate the amount of the annual revenue three times for each of the three prices: ?1.50, ?2 or ?2.50 per litre. In this way we obtain three different results for year one.
Then the procedure is repeated for year two and all subsequent years.