Question
ZXY Company is a food product company. ZXY is considering expanding to two new products and a second production facility. The food products are staples with steady demands. The proposed expansion will require an investment of $7,000,000 for equipment with an assumed ten-year life, after which all equipment and other assets can be sold for an estimated $1,000,000. They will be renting the facility. ZXY requires a 12 percent return on investments. Recommend if they should make the investment.
As the accounting manager, review and provide a recommendation on the expansion based on information that has been provided.
Prepare and support the recommendation to either make the investment or not, include the following items as part of the analysis:
• Analysis of financial information.
• Identification of risks associated with the investment. Consider:
• How risky the project appears
• How far off your estimates of revenues and expenses can be before your decision would change.
• The difference if the company were to use a straight line versus a MACRS depreciation.
• Recommendation for a course of action.
• Explanation of criteria supporting your recommendation.
As part of the analysis additional information from marketing, accounting, or finance would be useful in making an informed and well-supported recommendation. For the purposes of the assignment, you can make assumptions about the values of that data or ratios in support of the recommendation.
Accounting worked with the marketing group to create the ZXY Company Financial Statements spreadsheet for the new products business and the new facility.
Notes about the financial information:
• The expense line labeled SQF FDA Mandates refers to the costs of complying with Food and Drug Administration requirements.
• Depreciation expense is calculated using 7-year life modified accelerated cost recovery system (MACRS).
This report is for a mid-management audience and may be shared with others, so the materials should be designed for clarity and readability.
The report should include the following:
• Apply principles of accounting to assess financial performance.
o Analyze financial statements for decision support.
o Explain risks associated with an investment decision.
• Analyze accounting information to support business decisions.
o Recommend a course of action based on financial information.
o Explain how financial criteria support a decision.
• Communicate financial information with multiple stakeholders.
Solutions
Financial Information Analysis
Business financial data is meaningful, especially when it is applied in decision making processes by stakeholders. The managers are the internal major users of business data, although their access to the information is dependent on rank that range from low-level, middle-level, to top-levels. The leaders are responsible for strategizing by analyzing the data, which helps them to make informed decisions; for instance, in the ZXY Company, the managers are interested in whether the business will incur losses if they choose to invest and the viability of the decision. The management investigates whether the revenue and the salvage value of the equipment can cumulatively exceed the cost of purchasing. In addition, the managers can identify errors in the data provided as the analysis can portray trends, inconsistency, and misrepresentations. Financial information can also express deviations from the real expected proceeds and costs, such as if the decision made by managers fails, there is an allowance for uncertainties to assist in mitigating losses. While analysis of financial information is hereby applied, it is identifiable that some risks can influence prediction, and suitable counteractive measures can be implemented for the ZXY to be profitable in using the equipment.
Identification of Risks Associated with the Investment
The use of the equipment for the next ten years is not guaranteed. One of the issues that may arise is financial crisis, which can reduce the sales made from the equipment, thereby compromising productivity. In addition, the equipment face the risk of being inappropriately handled by the employees, which may lead to damage and further decline in value. Consequently, the employees require proper training so that they do not operate the machinery against the expected procedures, or strain them with overwork. Improper handling, lack of regular maintenance, can cause faster and higher depreciation as well as mechanical failures against the equipment manufacturer’s purposed lifespan. In the face of natural disaster, the equipment can cease functioning as they may be damaged by extreme conditions, such as rain or a fire. Notably, a shift in environmental factors can be influential on the modification that the equipment would require. For instance, the establishment of a new law may limit the operations of the equipment as in such instances modification of the design may be necessary to ensure that it is aligned to the new policies, resulting in extensive costs. Therefore, it is noted that purchasing the equipment itself transfers all the risks to the ZXY Company.
Magnitude of the Project
While there are imminent risks, the project can be managed in various ways to mitigate the probable challenges. Particularly, training employees regarding various aspects of the machinery’s operations, such as appropriate procedures, suitable food materials to be fed into the equipment, and safety measures, among others can enhance the efficiency and lifespan of the machine. In addition, the company can manage avoidable failures through regular maintenance schedules for the equipment’s performance. The most appropriate management of risk is to ensure that the instrument can be scrutinized before purchase to ensure that some of the issues are identified, and the manufacturing company makes the necessary adjustments or corrections. The equipment manufacturing company can further guarantee to cater for some forms of failures that can arise within a certain period, further providing relief for ZXY Company over any maintenance costs and requirements.
How Far the Estimates of Revenues and Expenses Can Be Before the Decision Changes
The estimates of revenue expected by ZXY can be affected by several factors, such as financial crisis and lack of competitiveness in the organization. Therefore, a reduction in income can be significant to the decision making process. However, the present values of the revenue can be evaluated to establish if they match the cost of equipment acquisition. If the values are less than the $7,000,000 for the instrument’s acquisition, it will not be viable to purchase the machines. The rate of 12% is applied on the revenue, resulting in the following.
Figure 1: Discounted Revenue
Clearly, the net present value (NPV) of obtaining the machine is higher than the purchasing value as the company will realize the breakeven point between its 3rd and 4th years of the equipment possession. In addition, an increase in taxation rates can affect the revenue. While the company can transfer the additional tax to the client, it can only do so for particular percentage, and absorb the rest of the cost, thus facing reduced revenues.
Difference if the Company is Using Straight Line Depreciation versus MACRS Depreciation
Figure 2: Straight Line Depreciation Method
Figure 3: Depreciation Using the MACRS Method
There are observed differences between the MACRS and straight line depreciation methods for the value of the machines. The straight line method allows for consistency in the depreciation values on the equipment; thus, by deducting the salvage value from the purchase value and divided over the usage life of the instrument, the value of the machinery for each productive year is identifiable. On the other hand, the MACRS method considers the mid-year convention, and 150% declining balance, which changes to the straight line method with some consistency in depreciation occurring from the 6th and subsequent years after the equipment starts operating. The business usage percentage of 100% is applied since the equipment will be solely utilized in the organization; hence, the values vary from those of straight line method since MACRS allows for income tax deduction so that ZXY can recover its costs of acquisition. Therefore, there are reduced tax deductions in the later years of the equipment’s performance.
Recommendation and Justification of the Course of Action
From the analysis based on mulitple diverse factors, ZXY Company can purchase the equipment. Observedly, the revenue expected can be recovered by the end of the fourth year; thus, the business is assured of its return on investment (RoI). The company considers 12% as the RoI, and it is clear that the NPV exceeds the value of $7,840,000 that the company seeks to realize after adding the interest. Furthermore, it is observable that the company will still attain the value of $1,000,000 after selling the equipment, which further adds to the returns even after use. In addition, the organization can implement the measures to prevent and avoid risks in oder to minimize deviation from the real revenue values. Therefore, the business can purchase the equipment with negligible chances of gaining losses or not attaining the RoI, if the necessary precautions are observed.
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