Question

Hey guys, could you please help with the below case study.

1. The cash flows at the start.

2. The cash flows over the life.

3. The cash flows at the end.

4. What is the NPV of the proposed Engadine store, and your recommendation?

1. Michael Hill International Limited (hereafter known as “Michael Hill”) ordinary

shares are listed on the Australian Securities Exchange (ASX). Michael Hill owns and

operates approximately 300 retail jewellery stores across Australia, New Zealand and

Canada. According to the ASX announcement made by Michael Hill on Date: 27/08/18 and

Headline: Investor Presentation, part of Michael Hill’s planned capital expenditure of $25

million is to open new stores. Michael Hill has already performed a substantial amount of

data analysis related to one particular planned new store in the southern Sydney suburb of

Engadine. However, the capital expenditure associated with the construction of a new store

and the operating expenses are substantial. Therefore, before Michael Hill commits to

building the new store a financial analysis is needed to determine if it will contribute to the

goal of creating wealth for its shareholders.

2. You are employed in Michael Hill’s corporate finance department and have impressed

senior management with your aptitude for financial analysis. This talent was developed

through the practice-oriented assignments that you completed at University. You recall how

exciting it was learning about listed companies by searching and reading announcements

made to the ASX. The Chief Financial Officer (CFO) has asked you to perform a financial

analysis of the planned Engadine store using a purpose-built preformatted EXCEL

spreadsheet. The CFO has suggested you liaise with company employees from a variety of

different departments to collect the information that is necessary to perform the analysis. You

will also search through public documents to identify some of the assumptions that will be

required in your financial analysis, and certain additional information. Your analysis will be

provided to the Board of Directors who must approve substantial capital expenditures.

3. The two major cash outflows associated with a new store are the cost of the building

and the fixtures and fittings such as specialised jewellers’ equipment and display cabinets.

The directors are accountable to the shareholders and so a financial analysis is necessary to

be confident that the investment in the new Engadine store is justified. The following

paragraphs contain a substantial amount of information that has been gathered from across

the business and it is your job to determine which information is relevant to the analysis.

4. The capital cost of the Engadine building is expected to be $2.3 million today.

Michael Hill has $7.2 million cash and it plans to use $1.6 million of this amount to pay for

the building which will reduce the cost to just $700,000. If the new store is built, some

redundant jewellery equipment must be sold. The equipment had a total capital cost in 2016

of $600,000 and for tax purposes have a ten-year life. The equipment can be sold today for

$130,000 and Michael Hill will use the sale proceeds to distribute a $130,000 dividend to its

shareholders today.

5. According to the Investor Presentation Michael Hill recently completed a

comprehensive brand review to respond to a changing consumer landscape. This review cost

$375,000 and there is debate among management about whether the cost of this review

should be classified as a tax-deductible expense in the financial analysis.

6. The annual sales for a new store are difficult to predict. However, Michael Hill is

confident that the Engadine store can achieve sales in the first year of operation that are

similar to an ‘average’ Michael Hill Australian store. You read the Investor Presentation to

identify the following two figures relevant to MICHAEL HILL AUSTRALIA for the year

ending Jun-18:

a) Revenue

b) Total stores open

You use these two figures to calculate an average revenue figure per store for 2018.

7. Since Michael Hill plans to build the new store in the year 2019, for capital budgeting

purposes the first year of revenue is expected in 2020. However, the retail environment is

very challenging as evidenced by the disappointing Australian same-store sales growth rate

stated in the Investor Presentation. Therefore, you forecast that the Engadine store’s

revenue in 2020 is equal to the average revenue figure per store for 2018 that you calculated

in Paragraph 6 compounded by the same-store sales growth rate. Beyond 2020 revenue is

forecast to increase by 2% p.a. reflecting the benefits of the brand review.

8. The Investor Presentation states the business has gross profit margins of

approximately 63%. Therefore, your analysis assumes that costs of goods sold at the

Engadine store are 37% of revenue. Fixed costs at the Engadine store in 2020 are $240,000.

Management is confident that with rigorous cost control they will be able to contain the

increase in fixed costs to 2% p.a. for each subsequent year. If the Engadine store is built,

Michael Hill anticipates that total cash operating expenses will equal 26% of sales.

9. Starting in 2020, employees at the Engadine store will receive annual training.

Michael Hill performs all training in-house using a dedicated facility that was established in

2017. The facility has an annual budget of $655,000 and inducts new employees in all aspects

of the jewellery business. Ordinarily, Michael Hill would charge an arms-length amount of

$75,000 per annum for staff training. However, the training division has sufficient spare

capacity to train the Engadine store’s employees without the facility incurring any additional

costs. The accounts department recommends internally invoicing the $75,000 training

expense to the Engadine store each year.

10. For taxation purposes the new building has a twenty-year life. However, Michael Hill

will perform the financial analysis of the Engadine store over a ten-year period. The new

store requires $300,000 of display cabinets. The Australian Taxation Office (ATO) confirms

that display cabinets have an eight-year tax life. In Michael Hill’s experience, display

cabinets be operated effectively for a full ten years before they need replacing. Michael Hill’s

management accountants depreciate all assets over an operational six-year life.

11. Michael Hill’s Research & Development department has spent $130,000 in recent

years developing a wedding ring sizing app. This project is still several years away from fullscale release but to ensure this expense generates the required returns the directors want to

include it in the analysis of the Engadine store as a cash outflow in 2019.

12. Michael Hill will borrow $1.2 million today to finance the Engadine store. The tenyear interest-only loan has annual interest repayments of $48,000 (assuming a 4% p.a. rate).

Michael Hill’s accountant confirms that interest payments are classified as a business expense

and are therefore tax deductible.

13. To promote the new Engadine store the marketing department has budgeted $85,000

of advertising for the store’s opening in 2020. Because this expense will reduce the new

store’s profitability in 2020, managers have suggested that the advertising expense be spread

out over the new store’s ten-year useful life. The ATO states that expenses associated with

the Engadine store’s grand opening can be claimed as a business expense in the year incurred.

Michael Hill’s total advertising budget for 2020 is $3.4 million and predicted to increase by

$200,000 each year. If the Engadine store opens, the annual advertising budget will remain

unchanged. For cost accounting purposes Michael Hill must allocate overheads across each

business unit. Therefore, it is proposed that the Engadine store be assigned a fraction of 1/171

of the total advertising budget.

14. Michael Hill assumes that the Engadine building can be sold for $400,000 in the year

2029. At any point in time the resale value of the display cabinets is just $26,000. In ten

years’ time Michael Hill assumes that it will have cash holdings of $4.4 million. You note the

ATO regulation that all non-current assets be depreciated to zero.

15. If the Engadine store proceeds, then Michael Hill will implement a private placement

to raise $800,000 from institutional investors to fund the store. The CEO’s annual salary in

2018 is $1,511,738 and is not expected to change whether the Engadine store opens or not.

16. If the directors approve the Engadine store Michael Hill anticipates that it will require

an additional $400,000 of inventory today on top of the existing level of $1.5 million, and

accounts payable will increase by $270,000. The accounts receivable balance will increase

from the current level of $5.4 million to $6.2 million if the Engadine store proceeds.

17. Michael Hill has a required rate of return of 9%. Assume the company tax rate will

remain at 30%.

Answer 1

1.Cash flows at the start:
Cash outflow towards building cost	-700000
Tax savings on sale of old jewellery(wkgs.)	87000
Display cabinets	-300000
Investment in Working capital
Increase in inventory	-400000
Increase in a/cs. Payable	270000
Increase in a/cs. Receivables	-800000
Net cash flow at start	-1843000
2. The cash flows over the life (10 yrs.)
From Page 26--Segment results
Michael Hill Australia
For the Fiscal 2018
Revenue('000s)	325709
No.of stores	171
Av. Revenue/store ('000s)	1904.73
Revenues growth rate(av.)	2.24%
revenue in 2020(1904.73*1.0224)(wkgs.)	1947
Year		1	2	3	4	5	6	7	8	9	10
1.Revenues		1947000	1990612.8	2035202.5	2080791.1	2127400.78	2175054.6	2223775.78	2273588.36	2324516.74	2376585.91
2.COGS(37%)		-720390	-736526.74	-753024.93	-769892.69	-787138.29	-804770.19	-822797.04	-841227.69	-860071.19	-879336.79
3.Fixed costs		-240000	-244800	-249696	-254689.92	-259783.72	-264979.39	-270278.98	-275684.56	-281198.25	-286822.22
4.Cash opg. Exp.(26%*revenues)		-506220	-517559.33	-529152.66	-541005.68	-553124.2	-565514.19	-578181.7	-591132.97	-604374.35	-617912.34
5.EBT(1+2+3+4)		480390	491726.74	503328.93	515202.77	527354.571	539790.79	552518.059	565543.133	578872.942	592514.57
6.Tax at 30%		-144117	-147518	-150999	-154561	-158206	-161937	-165755	-169663	-173662	-177754
7.EAT(5-6)		336273	344209	352330	360642	369148	377854	386763	395880	405211	414760
8.Add: Depn. Tax shield(bldg.(2300000/20*30%)		34500	34500	34500	34500	34500	34500	34500	34500	34500	34500
9.Add: Depn. Tax shield(Display cabinets(300000/8*30%)		11250	11250	11250	11250	11250	11250	11250	11250
10.Add: Interest tax shield(48000*30%)		14400	14400	14400	14400	14400	14400	14400	14400	14400	14400
11.Net annual operating cash flows(7+8+9+10)		396423	404359	412480	420792	429298	438004	446913	456030	454111	463660
3. The cash flows at the end.
After-tax cash flow on sale of bldg.(wkgs.)											625000
After-tax cash flow on display cabinets(26000*(1-30%)											18200
Recovery of working capital											930000
Net annual cash flows	-1843000	396423	404358.72	412480.25	420791.94	429298.2	438003.56	446912.641	456030.193	454111.06	2036860.2
PV F at 9% (1/1.09^1)	1	0.91743	0.84168	0.77218	0.70843	0.64993	0.59627	0.54703	0.50187	0.46043	0.42241
PV at 9%	-1843000	363690.83	340340.64	318510.44	298099.62	279014.374	261167.21	244476.519	228866.176	209085.347	860391.761
NPV of investment in new store	1560643

Workings:
Carrying value of the redundant jewellery in Year 0(2019)(600000-(60000*3)=	420000
Sale value	130000
Loss on sale	290000
Tax cash outflow saved on loss	87000
Carrying value of Building in Year 10(2029)(2300000-(2300000/20*10)=	1150000
Sale value	400000
Loss on sale	750000
Tax cash outflow saved on loss	225000
After-tax cash flow on sale of bldg.	625000
	Year	Revenues	(2015-2014)2014
	2014	298474
	2015	294442	-1.35%
	2016	309457	5.10%
	2017	321981	4.05%
	2018	325709	1.16%
		Av. Growth rate=sum/4=	2.24%