European Expansion Historical Analysis
To make a decision about expansion to Europe, we must first analyze past performance as an indicator about future performance. A historical analysis was completed on the company’s past balance sheets.
Custom Snowboards Inc. has had increased net sales in the past three years. Net sales went up .23% in year 13 and .93% in year 14. Cost of goods sold (consisting of direct material, labor, and overhead) and in relation Gross Profit, also increased by the same percentages. Using the historical data, we use the trend analysis to determine what sales will be like in future years. The company’s trend analysis shows this increase in net sales and gross profit will continue well into year 17. Using base year 12, historical data shows an increase to 100.2% in year 13 and another .7% increase to 100.9% in year 14. Then to further review the upcoming year’s predictions, Custom Snowboards uses year 14 as the base year at $6,955,200. Year 15 increases to $7,163,856, a 3% increase. Year 16 slows slightly to $7,094,304, down a percent from year 15 but still an increase of 2% from the base year. Year 17 shows net sales at 103.7% of the base year 14 earnings. This indicates the company has worthy cost control in revenue.
When reviewing European sales forecast for years 15-19, we see the same trend as with Custom Snowboards Inc. trend analysis. European net sales will increase from $1,391,040 to $2,423,748, or 74% during the 4 years. Using year 15 as the base year, in year 16, net sales are predicted to be 120%, 144% in year 17, 158% in year 18, and 174% in year 19.
Operating Expenses. The selling expenses that include transportation out, sales commissions, and advertising increased at the same rate as revenue. The related increase fluctuates with units sold as it should. This is another indication the company can manage its cost control. The future operating expenses in the European Sales forecast indicate that advertising expenses will decrease and sales commissions, transportation out, factory manager/ staff expenses will increase as expected with an expansion. The overall selling and admin expenses move from $215,048 in year 15 to $251,480 in year 19. Using year 15 as the base, there is expected 7% increase by year 16, 15% increase by year 17, 11% in year 18 and ending with a 17% increase by year 19. Coupled with the increasing net sales, this continues to show positive cost control.
General and admin expenses increased disproportionately. In year 13, the expenses increased an overall 7.24% and another 6.50% in year 14. The hardest hit areas in this area are the other general and admin expenses in year 13 and compensation in year 14 bringing the total operating expenses to an increase just over four percent each year. Since compensation increased, this could mean additional employees. More workers would explain why an increase in utilities. Since sales went up, it would be justified in the employee increase however, the percentages should be more similar. Expenses should have gone up a smaller percentage, one closer to the .23% and .93% numbers shown in net sales. Expenses growing at a faster rate than sales is poor cost control.
Net earnings shows a trend of declining over the past few years by 25-30%. This decrease – and another unfortunate cost control – is mostly due to the decline in interest income. Interest went down 28% in year 13 and 90.63% in year 14. The interest income could be influenced by the fact that short term investments also declined in year 14 by 83.3%. Interest expenses decreased as well indicating that Custom Snowboards Inc. is paying the minimum payment on the amortization schedule instead of paying on the principle.
Assets. Cash and cash equivalents increased for Custom Snowboards Inc. 114.2% in year 13 and another 30.6% in year 14. Consistent increase shows well for the company but since sales went up 23% in year 13 and .93% in year 14, the cash should have increased more in year 14 however, furniture, fixtures, and equipment went up 200,000 which means the company purchased more assets for the company. Custom Snowboards is putting the money back into the company without taking on more debt which indicates a decent cost control. Custom Snowboards most likely took money from their short term investments to pay for the furniture. The short term investments dropped significantly in year 14 by more than 80%. This caused a decrease in total current assets but the overall total assets remained healthily increasing, partly due to increase in finished goods and raw materials inventory. Overall, Custom Snowboards uses respectable cost control in assets.
Liabilities. Accounts and notes payable increased proportionately to the net sales increasing total current liabilities by the same proportions. Mortgage payable decreased consistently over the three years as did other long term liabilities. Overall, liabilities continued to decrease over the three year period.
Stockholders Equity increased over the three year period. Common stock remained steady at $200,000 ($1 par) and so did paid in capital. Retained earnings increased every year, a plus for the bank. Return on total assets, return on common equity, and price/ earnings ratio are significantly higher than the competition, Winter Sports. Overall the company remains stead and the bank can deduct from reviewing the financial statements that the company will continue to make strong decisions and increase net worth over the next few years.
Cost Control Improvements
Custom Snowboards has good cost controls in place however some improvements can be made. The company currently uses Traditional Cost Base (TBC) method by using a predetermined overhead rate and then costs are divided evenly among the products regardless of what is actually used. This does not give a true picture of costs. For the most part this is working well but the company could use better cost control by implementing the Activity Based Costing method. In this method, overhead manufacturing costs are divided in a more rational and deliberate manner. Costs are allocated by how much it actually costs to make a specific product group. Each product would be placed in a group with other items with the same costs, regular vs personalized snowboards for example. This includes labor hours, machine costs, etc.
Although the ABC method is more complex and time consuming, it will be worth it to Custom Snowboards. The company will be able to better assess how and where money is spent and drive down expenses and increase net earnings. In the specific case of Custom Snowboards two types of boards, regular and personalized, the ABC method helps the company manage its money. In traditional costing, the regular bikes are $119 per unit. The personalized snowboards are $162. However, using activity based costing, the regular bikes are only $105 per unit and the personalized units are $218 each. In total production costs, the company is spending $522119 more on regular bikes than it would using ABC, and [$522119] less than it should on personalized bikes. This shows that in TBC, too much money is allocated for the regular snowboards, and not enough for the personalized units. The company needs to improve its cost controls with the ABC method to decrease expenses and increase profits.
Another way the company can control more of its costs are to itemize and budget ore specifically. Line items like other general and admin expenses should be much smaller and contain items that are tracked. Having a more specific budget can also allow the company the opportunity to seasonalize its budget as well. Utilities may go up in the winter because of heat, or up in the summer due to air conditioning. Snowboard sales are more likely to be higher in the months leading into winter than the summer months. Identifying seasonal funding requirements could save Custom Snowboards a lot of money and increase net profits.
Custom Snowboards can control costs by using aggressive funding strategies versus conservative ones. The cost of long term financing is more expensive than the cost of short term financing. Being aggressive in its borrowing, the company can lower interest expenses and raise net earnings. Short term investments are riskier because of the fluctuation in interest rates, but coupled with the tighter budget, the company should be able to predict when the best time to finance is.
Day to day activities can help control costs for Custom Snowboards. Collecting account receivable as quickly as possible but not losing customers from high-pressure collections, better customer service, faster and more efficient mail, processing, and clearing time reduction when collecting from customers (collection and disbursement floats), and controlled disbursing, paying accounts payable slowly (but still on time to avoid credit damage) are all ways to accomplish better cost control.
Inventories should be classified into three categories: raw materials, work in progress, and finished goods. Proper management should be strictly enforced to ensure funds are used wisely by keeping inventory low, but having enough inventory on hand to quickly fill orders and prevent production delays. This is in direct relation to knowing the seasonal demands of the products and predicted sales. If the company uses the ABC method, it can use the calculation Total Cost=(OxS/Q) + (Cx Q/2) where O = order cost per order, S = usage in units per period, and Q = order quantity in units. A re-order point (including lead time) should be set by management to determine when more materials should be purchased so as to not upset the balance.
The just in time (JIT) management system is ordering materials so they arrive at exactly the moment they are needed for production. This minimizes inventory investment but also takes extensive coordination with near perfect quality and consistency to be successful. The company must work with suppliers and shipping companies to ensure correct arrival times in addition to internal controls to make sure the correct items are ordered on time. Both Custom Snowboards’ raw materials inventory and finished goods inventory increased over the past three years. The JIT method will help the company keep these numbers under control.
Custom Snowboards is considering expansion into Europe either through merging with or acquiring European SnowFun, or by simply building a new facility. Mergers happen to improve a company’s share value, expand externally, diversify produce lines, reduce taxes, and increase owner liquidity. With the benefits of a merger, there are risks. The CEO of Custom Snowboards is concerned about internal operations risks associated with an expansion to Europe. She is also concerned about Custom Snowboards reaction to external risks encountered by the expansion as well.
Internal risks Custom Snowboards faces could have a negative impact on the daily operations of the company. These are the risks from circumstances the company has control over. For this merger, Custom Snowboards will need to consider internal loss of focus on current operations, cultural differences including the language barrier, different financial reporting systems, different customers, new monetary system, and new management.
Although the culture is an external factor, the way the company handles the risk is internal. The culture of the new market is vastly different and will need new strategies to continue sales regardless if the expansion is a merger or not. If Custom Snowboards does not understand its new customer base, it could lose sales quickly plummeting the company into bankruptcy. To mitigate this risk, research and development will need to do some work to help management communicate with a new market; associates, suppliers, shipping companies, etc.
Some gestures and nuances we use in the United States may not be used in Europe or vice versa. Something we think rude, may be acceptable there. They could be offended by something innocent to us resulting in sales loss. The marketing department will also need to adjust the way it relates to customers. What sells in American, may not see in Europe. The use of multiple new languages will also need to be addressed. Bilingual employees, particularly the customer service representatives would be beneficial and help mitigate the risk of losing customers to a language barrier. It will also help the employees communicate with each other as many current employees will have to go to setup the expanded portion of the company. A look into the competition will assist the company quite a bit as well.
Increased costs in everyday business. Translators, new paperwork in different languages etc. must be mitigated with pre-planning and research. The company will need to complete new reports using International Financial Reporting Standards (IFSR) which could also be a costly change for the company. Even worse, the change in accounting standards could prove to be more costly if reported incorrectly. Proper training and understanding of the new system will mitigate this risk. All monies will need to be converted to the current system in that country as well. All costs should be pre-budgeted to ensure the company has enough cash flow for start-up costs as well as an operating budget. Realistic business plans should be in place. Hiring an outside local agency to assist in the accounting the first few years may be a smart way to invest into the company and mitigate the cost risk associated with an international expansion.
With all the focus on getting the new part of the company up and running smoothly, there is a tendency to let the current operations fall behind. Oftentimes companies will send their best people to assist with the expansion leaving behind employees who can barely keep the current operations afloat. This leads to missed deadlines, mismanagement of operations, and quality control issues. To mitigate this risk, the company should find a balance of more experienced employees as well as less seasoned ones for the project team.
The new management team can also be a risk to the company as foreign markets have different business practices. Business mistakes could cost the company money or its reputation. Inexperienced in how the company works, the new team will need lots of training. Custom Snowboards can mitigate this risk by ensuring an extensive training program is available as well as hiring qualified individuals in European business practices as well as those of the US. Offering some current employees benefits to work in Europe until the expansion portion of the company is up and running will also benefit the company. Keeping in mind of course, the balance of current operations and those of the expansion. The new management team may also have different management styles. This could be good for the company as it tries to adopt the European market business culture.
In addition to cultural barriers, another external risk is the local laws and regulations of the expansion country. In addition to the IFSR, there are specific laws that must be followed. This includes local labor, wage laws. Without knowing these laws, the company could inadvertently break them, leading to large fines, legal action against them, or being disallowed from doing business there. The best way to mitigate these risks are to educate, educate, educate. Custom Snowboards must learn the new laws and ensure everyone is trained on following them. A quality team should be in place to follow up on compliance as well as a consultant to get things going.
External market plays a role in the success of the expansion. GDP growth rate, interest rates, consumer growth rate, the unemployment rate, etc. can all effect business for the company whether it is in the form of shipping costs or sales. To mitigate this risk, the company should do a thorough analysis of the market and benchmarks set prior to making the commitment to expand.
The company should also take into consideration any political issues in the new country as this could cause instability and effect the market. So do government regulations and tariffs so Custom Snowboards should research, analyze, and be prepared.
To make the most informed decision about expanding to Europe, we must look at the potential returns for the investment. The company will fund the expansion through increasing capital structure. To analyze potential returns, we look at net present value (NPV) and internal rate of returns (IRR).
The NPV measures profitability which is the main goal of any business. It identifies the dollar amount the company will make from the project, using the current rate. An in depth look at Custom Snowboards capital budget reveals the NPV for the expansion via a new facility is $167,479. A positive NPV is an indication the company should move forward with the expansion. Had the NPV been zero, or less, the venture should have been rejected. An analysis of NPV for the merger has not been conducted.
The IRR, also known as the expected rate of return, is the point in which the project’s cash flow equals cost. This too will tell Custom Snowboards if the venture will be profitable. The hurdle rate set by Custom Snowboards is 10%. Which means if the IRR falls below that, the company does not feel the investment is worthwhile. If the IRR is above 10%, the company should move forward. The IRR for Custom Snowboards was analyzed for years 15 through 19 with $1,000,000 investment, the IRR is 14.4%. This indicates the company should move forward with the expansion.
Both potential returns indicators demonstrate Custom Snowboards the expansion is a viable option and should be moved on. The company should accept the project as the expected return on investment would prove a significant asset.
Merger vs Acquisition
Since the company knows now that an expansion is the way to go, it must then decide if a merger is appropriate. The growing percentage of total sales is expected to continue rising. The company can opt to expand to Europe by way of building a new manufacturing facility with a lease option or by merging with SnowFun, a European company. Custom Snowboards can also acquire SnowFun. SnowFun’s product is less durable but offers a personalized paintjob that increases sales. Custom Snowboards Inc. uses 10% hurdle rate for capital budgeting and expansion decisions. Merge. The IRR discussed earlier indicates the merger will be a profitable decision for the company at 14.4%. The NPV for the merger was established at $167,479, both indicating the merger will be profitable. Merging with SnowFun means shareholders of SnowFun would stock swap three of their existing shares for one share of the combined company.
The stock purchase price for the company after merger would be $2.40 per share. SnowFun has 300,000 currently outstanding. Which would mean 100,000 shares of Custom Snowboards would now be owned by former SnowFun shareholders, diluting the shares owned by Custom Snowboards stockholders. Expected earnings per share (EPS) after a merger would decrease .06 to .92. The EPS for European SnowFun is currently at a low .27 but will increase dramatically to .92. The company would have to decide if the value decline in EPS for Custom Snowboards is worth the increase from European SnowFun stocks. Positively, the merge would provide the company with pre-established workforce, facilities, and customers. As discussed, this can also be a risk to the company.
Building a new facility means spending $800,000 on building and equipment and, $200,000 working capital is required for startup. The build option will increase assets for the company while simultaneously return profits. The build option will cause the company to incur debt. Custom Snowboards has decided that if this option is chosen, the company will fund the expansion through increasing capital structure. The company would raise capital by issuing long term debt, sale of common stock, or a combination of both. All of these options effect the company’s financial leverage. It is recommended that both be done to maximize the value of the company for shareholders.
Custom Snowboards could enter into a sale-leaseback at 6%, or purchase a preexisting facility over time, also at 6%. The shorter term lease would be the most beneficial to the company. The annual loan payment would be $189,917.12 versus the annual lease payment would be $195,000. The $5,082.88 yearly difference is an acceptable risk in this venture as the lease option preserves more working capital. The lease option requires cash outflows of $653,355 while the purchasing option requires outflows of $809,409, a $156,054 difference. Custom Snowboards Inc. can reinvest that money back into the company. This option provides tax advantages rather than paying property taxes. The purchasing option will have the company pay property taxes but will also provide advantages by way of depreciation.
The total present value for an acquisition is $732,522. After a $720,000 purchase price, this would put the NPV for acquisition as $12,522. This makes an acquisition a profitable measure as well. This option is less expensive up front and still increases the company’s assets. Acquiring SnowFun would also mean a stock purchase price of $2.40 per share. With 300,000 outstanding shares, that means $720,000. This option also provides the benefits of an established workforce, facilities, and customers, and the risk that comes with that.
Based on the analysis above, it is my recommendation that Custom Snowboards expand to Europe using the build with leasing option building the most working capital than the other options. The NPV indicates the investment will have a positive return on investment as does the IRR. A merger or acquisition would eliminate SnowFun as a threat however their inferior product and outstanding stocks would decline business for Custom Snowboards. The risk of the preexisting structures and products is greater than the company should accept. The tax advantages would contribute to the working capital of the company. The excess working capital the company gains from the expansion, can be placed back into the company, covering the startup costs. As the company builds its own reputation in Europe, a future acquisition may be more feasible. Custom Snowboards product is higher quality therefore, it may force SnowFun into a position of being acquired at a lower rate in the future.
In selecting this option, the company must lastly choose how to fund the decision. There are a few ways to finance the build. The capital structures are: 100% long term debt, 30% long term debt and 70% common stock, 80% long term debt and 20% common stock, and 100% common stock with no long term debt. The long term debt will yield an average .47 earnings per common stock (EPCSS). The least beneficial to the stakeholders. In year 15, the earnings before interest and tax (EBIT) is $81,912, the income available for common stock is $10,809, bringing the EPCSS to .054. In year 16, the EBIT is $134,544, the income available for common stock is $50,283, and the EPCSS is .251. In year 16, this option yields the best results. In year 17 with an EBIT of $198,116, the income available for common stock is $97,962, and the EPCSS is .490, .703 in year 18 with EBIT $254,959 and $140,594 income available for common stock, and with an EBIT of $295,639 and $171,104 income available for common stock in year 19, a yield of .856. Using the long term debt option will look the least beneficial to the stakeholders in the first year, but then maintains the best return for all subsequent years.
The 30/70 option will yield in year 15, an EPCSS of .084, .156 in year 16, .243 in year 17, .320 in year 18, and .376 in year 19. This is the second best option in year 15 but in the middle for the other years. On average, this option will yield .236 EPCSS, making this the second worst option. The 80/20 option will yield an EPCSS of .070 in year 15, .201 in year 16, .360 in year 17, .502 in year 18, and .604 in year 19. This option isn’t bad in year 18 but not the best for the other years. This option will yield .347 on average. The no debt option will yield an EPCSS of .088, the most beneficial in year 15. In year 16, the EPCSS is .144, .212 in year 17, .273 in year 18, and .317 in year 19 making this the least beneficial of all the options the rest of the years. Over the course of the 5 years, this option will yield .207 EPCSS, the least return of all options.
Although the benefits start slow with a lower EPCSS in year 15, my recommendation is to fund the build with the long term debt option. Although the 100% common stock option produces more income available for common stock, the long term debt option will yield the highest returns at an average EPCSS of .477. Longevity will prove to work best in this scenario. Over time, this option will yield the most benefits to the stakeholders. Securing capital in this way will ensure the highest earnings, producing more income for common stock money for future investment into the company.