Case Study

Problem
Case

Ben Guslits, vice-president of sales, has recommended adding a new product line. A market Study and
cost analysis show that the new line shoule yield the following annual results:

Net Sales 2,800,000.00

Cost of Sales 1,600,000.00
Operating Expenses 200,000.00
Total Expense 1,800,000.00
Income Before Tax 1,000,000.00
Income Tax (40%) 400,000.00
Net Income 600,000.00

Depreciation of $150,000 is included in the total expenses. Cost of Sales and operating expenses include
only direct cost of the new line.
 Case

Net Sales 12,000,000.00

Cost of Sales 7,500,000.00 Total Asset 12,000,000.00
Operating Expense 1,800,000.00
Total Expense 9,300,000.00 Current Liabilities 3,000,000.00
Operating Income 2,700,000.00
Long Term Debt 1,000,000.00
Interest expense 100,000.00
Income before Income Taxes 2,600,000.00 Equity 8,000,000.00
Income Tax 1,040,000.00
Total Liabilities and
Net Income 1,560,000.00 Equities 12,000,000.00

Depreciation expense included total $400,000 for the firm.

Case
The investment in additional equipment for the production and sale of the new product line has been
estimated at $3,000,000.00. “The new product line will yield a 20% return on assets.” Guslits states.

Steve Grunward, the vice president of production, interrupts. “Are you talking about a cash flow
return, Ben?” he asks. “No.” Guslits answers. “When depreciation is added back, the cash flow return
will be even greater.”

The vice president of finance, Jude Gallagher, asl, “How do you think we should finance the
investment?”

“We should be able to issue long-term notes.” Guslits responds. “Our debt at the present is modest.
And, with debt financing, we gain the advantage of leverage.”

“In your estimate, Ben, you forgot to include any interest cost. It will cost us $150,000 after income
taxes to finance $3,000,000.” Gallagher replies.
 AFTER NEW PRODUCT
NEW PRODUCT LINE CURRENT LINE

Net Sales 2,800,000.00 12,000,000.00 14,800,000.00

Cost of Sales - 1,600,000.00 - 7,500,000.00 - 9,100,000.00

Operating Expense - 200,000.00 - 1,800,000.00 - 2,000,000.00

Interest - 100,000.00 - 100,000.00

Income 1,000,000.00 2,600,000.00 3,600,000.00

Tax - 400,000.00 - 1,040,000.00 - 1,440,000.00

Cost after tax     - 150,000.00

Net Income 600,000.00 1,560,000.00 2,010,000.00

 AFTER NEW
NEW PRODUCT LINE CURRENT PRODUCT LINE
Depreciation 150,000.00 400,000.00 550,000.00

Net Income +
Total Cash Inflow 750,000.00 1,960,000.00 2,560,000.00 Depreciation

Return in Asset 20% 20%

Total Assets 12,000,000.00 15,000,000.00 (=12,000,000 * 20%)
Equipment needed 3,000,000.00 Net Income / ROA

Current Liab 3,000,000.00 3,000,000.00

Long Term debt 3,000,000.00 1,000,000.00 4,000,000.00
Total Liability 3,000,000.00 4,000,000.00 7,000,000.00

Equity 8,000,000.00 8,000.00

Total Liab and Equity 3,000,000.00 12,000,000.00 15,000,000.00
Requirements
Requirements

1. What impacts will the new product line have on profit measures and cash
flows?
2. Examine and comment on Guslits’ strategy to finance the investment. Is it
likely that shareholders will impressed with the investment? Why?
3. In your opinion, is the investment attractive? Explain your answer.
Requirement 1
What impacts will the new product line have
on profit measures and cash flows?

Answer:

Cash inflows after implementation of the new product line will be

$2,340,000.00 compared to last year with only $1,800,000.00.
The implementation of the new product line will result a net profit
of $2,010,000 compared to the net profit last year with only
$1,560,000.00.
Requirement 2
Examine and comment on Guslits’ strategy to finance the
investment. Is it likely that shareholders will impressed with the
investment? Why?
Current After New product
Current After New product
Total Liability 8,000,000.00 8,000,000.00
Net Income 1,560,000.00 2,010,000.00
Equity 12,000,000.00 15,000,000.00
Total Cash Inflow 1,960,000.00 2,560,000.00
Debt to Equity 50.00% 87.50%

Guslits chose to used debt financing to finance the new product line of
the company rather than issuing share of stocks or equity investment. By
choosing issue long term debt to finance the new line, the company's
debt to equity will increase to 87.5% compared to last year’s 50% before
the new line, making them highly leveraged and exposing them to a
possible default in a worst case scenario. However, the gain outweighs
the cost of paying the interest.
The new investment will impress the shareholders because both the
overall profit and cash inflows significantly increased.
Requirement 3
In your opinion, is the investment attractive?
Explain your answer.
Current After New product
Debt Ratio 0.33 0.47
Profit Margin Ratio 0.13 0.14
 Requirements

Current After New product

Debt Ratio 0.33 0.47
Net Profit Margin Ratio 13% 14%

Overall the new investment is still attractive as it is more profitable even though it
became more leveraged. Even though it is a big investment in terms of financing,
the debt ratio is still manageable and this means that the company has still at least
twice as many assets as liabilities. The net profit margin ratio also increased by 1%
given that this ratio includes tax expense aside from the other expenses, this means
that the business will do well after the implementation of new product line.