Question

In a distribution Company, the commercial area has the option to increase its market share through increasing sales of one product line that it owns. However, to achieve these sales the firm needs to increase inventory. Current sales are $3.5 millions and they can be increased by 15 % if the inventory tumover moves from 30 to 50 days. Gross profit margin is 70% in both periods, the opent operating profit margin is. 40% also in both periods, taxes are 33% and the WACC is given as follows: ke: 22% kd: 12% • Liabilities are 2.5 times the equity. > Should the new line comercial area products ? decide use to increase sales in the EVA criteria to decide. of Note: Use the year of 360 days. Assume that liability are 1000% debt and the assets are equivalent to the Assets Invested in Operation (AIO).

Answer 1

Answer-

Given

Sales of the firm = $ 3.5 million
Inventory turnover = COGS / Average inventory
Days of Inventory on hand (DOH) = 360 / Inventory turnover
Inventory turnover = 360 / DOH
Increase from 30 to 50 days

Inventory turnover = 360 / 30 = 12 ( sales = $ 3.5 million)

Increase in sales = $ 3.5 m x 1.15 = $ 4.025 million
Inventory turnover = 360 / 50 = 7.2 ( sales = $4.025 million)

Gross profit margin is 70% in both the cases
Gross profit margin = COGS / sales

In case of $ 3.5 million sales
70 % = COGS / $ 3.5 m
COGS = $ 3.5 million x 0.7 = $ 2.45 million
Average inventory = COGS / inventory turnover = $ 2.45 / 12 = 0.204 million
In case of $ 4.025 million sales
70 % = COGS / $4.025 m
COGS =  $ 4.025 m x 0.7 =$ 2.82 million
Average Inventory = $ 2.82 / 7.2 = 0.392 million

Operating profit margin = 40 % in both the cases
Operating profit margin = EBIT / sales
In case of $ 3.5 million sales
40 % = EBIT / $ 3.5 m
EBIT = $ 3.5 m x 0.4 = $ 1.4 million
In case of $ 4.025 million sales
40% = EBIT / $ 4.025
EBIT = $ 4.025 x 0.4 = $ 1.61 million

WACC = wt. of equity x cos of equity + wt. of debt x cost of debt x (1-tax rate)
Given
cost of equity (Ke) = 22%
cost of debt (Kd) = 12%
Liabilities = 2.5 x equity
debt =2.5 x equity ( Here liabilities =debt)
debt / equity = 2.5 / 1
debt / (equity + debt) = 2.5 / (1+2.5) = 2.5 / 3.5 = 0.71
equity / ( equity + debt) = 1 / ( 1+2.5) = 1 / 3.5 = 0.29
Tax rate = 33%
WACC = 0.29 x 22 % + 0.71 x 12% x ( 1- 0.33)
WACC = 6.38 % + 5.71%
WACC = 12.09 %

Economic value added ( EVA) = [ EBIT x (1-tax rate) - $ WACC) ]
EVA is the value added to the shareholders of the company by the management during a given year.

$ WACC = invested capital x WACC

For sales of $ 3.5 million
Invested capital = COGS+ Inventory = $ 2.45 m +$ 0.204 m = $ 2.65 million
EVA = $ 1.4 X ( 1 - 0.33) - $ 2.65 x 0.1209
EVA = $ 0.938 m - $ 0.32 m = $ 0.618 million

For sales of $ 4.025 million
Invested capital = COGS + Inventory = $ 2.82 m + $ 0.392 m = $ 3.21 million
EVA = $ 1.61 m x ( 1 - 0.33) - $ 3.21 m x 0.1209
EVA = $ 1.078 m - 0.39 m = $ 0.688

Since we saw the EVA increased from $ 0.618 million to $ 0.688 million, so the commercial area can increase sales in the new line of products.