Question

Continued on from case study 8. According to the InvestorPresentation, what is one strategy that Michael Hill has plannedfor its cash flow? 1. Michael Hill International Limited (hereafterknown as “Michael Hill”) ordinary shares are listed on theAustralian Securities Exchange (ASX). Michael Hill owns andoperates approximately 300 retail jewellery stores acrossAustralia, New Zealand and Canada. According to the ASXannouncement made by Michael Hill on Date: 27/08/18 and Headline:Investor Presentation, part of Michael Hill’s planned capitalexpenditure of $25 million is to open new stores. Michael Hill hasalready performed a substantial amount of data analysis related toone particular planned new store in the southern Sydney suburb ofEngadine. However, the capital expenditure associated with theconstruction of a new store and the operating expenses aresubstantial. Therefore, before Michael Hill commits to building thenew store a financial analysis is needed to determine if it willcontribute to the goal of creating wealth for its shareholders. 2.You are employed in Michael Hill’s corporate finance department andhave impressed senior management with your aptitude for financialanalysis. This talent was developed through the practice-orientedassignments that you completed at University. You recall howexciting it was learning about listed companies by searching andreading announcements made to the ASX. The Chief Financial Officer(CFO) has asked you to perform a financial analysis of the plannedEngadine store using a purpose-built preformatted EXCELspreadsheet. The CFO has suggested you liaise with companyemployees from a variety of different departments to collect theinformation that is necessary to perform the analysis. You willalso search through public documents to identify some of theassumptions that will be required in your financial analysis, andcertain additional information. Your analysis will be provided tothe Board of Directors who must approve substantial capitalexpenditures. 3. The two major cash outflows associated with a newstore are the cost of the building and the fixtures and fittingssuch as specialised jewellers’ equipment and display cabinets. Thedirectors are accountable to the shareholders and so a financialanalysis is necessary to be confident that the investment in thenew Engadine store is justified. The following paragraphs contain asubstantial amount of information that has been gathered fromacross the business and it is your job to determine whichinformation is relevant to the analysis. 4. The capital cost of theEngadine building is expected to be $2.3 million today. MichaelHill has $7.2 million cash and it plans to use $1.6 million of thisamount to pay for the building which will reduce the cost to just$700,000. If the new store is built, some redundant jewelleryequipment must be sold. The equipment had a total capital cost in2016 of $600,000 and for tax purposes have a ten-year life. Theequipment can be sold today for $130,000 and Michael Hill will usethe sale proceeds to distribute a $130,000 dividend to itsshareholders today. 5. According to the Investor PresentationMichael Hill recently completed a comprehensive brand review torespond to a changing consumer landscape. This review cost $375,000and there is debate among management about whether the cost of thisreview should be classified as a tax-deductible expense in thefinancial analysis. 6. The annual sales for a new store aredifficult to predict. However, Michael Hill is confident that theEngadine store can achieve sales in the first year of operationthat are similar to an ‘average’ Michael Hill Australian store. Youread the Investor Presentation to identify the following twofigures relevant to MICHAEL HILL AUSTRALIA for the year endingJun-18: a) Revenue b) Total stores open You use these two figuresto calculate an average revenue figure per store for 2018. 7. SinceMichael Hill plans to build the new store in the year 2019, forcapital budgeting purposes the first year of revenue is expected in2020. However, the retail environment is very challenging asevidenced by the disappointing Australian same-store sales growthrate stated in the Investor Presentation. Therefore, you forecastthat the Engadine store’s revenue in 2020 is equal to the averagerevenue figure per store for 2018 that you calculated in Paragraph6 compounded by the same-store sales growth rate. Beyond 2020revenue is forecast to increase by 2% p.a. reflecting the benefitsof the brand review. 8. The Investor Presentation states thebusiness has gross profit margins of approximately 63%. Therefore,your analysis assumes that costs of goods sold at the Engadinestore are 37% of revenue. Fixed costs at the Engadine store in 2020are $240,000. Management is confident that with rigorous costcontrol they will be able to contain the increase in fixed costs to2% p.a. for each subsequent year. If the Engadine store is built,Michael Hill anticipates that total cash operating expenses willequal 26% of sales. 9. Starting in 2020, employees at the Engadinestore will receive annual training. Michael Hill performs alltraining in-house using a dedicated facility that was establishedin 2017. The facility has an annual budget of $655,000 and inductsnew employees in all aspects of the jewellery business. Ordinarily,Michael Hill would charge an arms-length amount of $75,000 perannum for staff training. However, the training division hassufficient spare capacity to train the Engadine store’s employeeswithout the facility incurring any additional costs. The accountsdepartment recommends internally invoicing the $75,000 trainingexpense to the Engadine store each year. 10. For taxation purposesthe new building has a twenty-year life. However, Michael Hill willperform the financial analysis of the Engadine store over aten-year period. The new store requires $300,000 of displaycabinets. The Australian Taxation Office (ATO) confirms thatdisplay cabinets have an eight-year tax life. In Michael Hill’sexperience, display cabinets be operated effectively for a full tenyears before they need replacing. Michael Hill’s managementaccountants depreciate all assets over an operational six-yearlife. 11. Michael Hill’s Research & Development department hasspent $130,000 in recent years developing a wedding ring sizingapp. This project is still several years away from fullscalerelease but to ensure this expense generates the required returnsthe directors want to include it in the analysis of the Engadinestore as a cash outflow in 2019. 12. Michael Hill will borrow $1.2million today to finance the Engadine store. The tenyearinterest-only loan has annual interest repayments of $48,000(assuming a 4% p.a. rate). Michael Hill’s accountant confirms thatinterest payments are classified as a business expense and aretherefore tax deductible. 13. To promote the new Engadine store themarketing department has budgeted $85,000 of advertising for thestore’s opening in 2020. Because this expense will reduce the newstore’s profitability in 2020, managers have suggested that theadvertising expense be spread out over the new store’s ten-yearuseful life. The ATO states that expenses associated with theEngadine store’s grand opening can be claimed as a business expensein the year incurred. Michael Hill’s total advertising budget for2020 is $3.4 million and predicted to increase by $200,000 eachyear. If the Engadine store opens, the annual advertising budgetwill remain unchanged. For cost accounting purposes Michael Hillmust allocate overheads across each business unit. Therefore, it isproposed that the Engadine store be assigned a fraction of 1/171 ofthe total advertising budget. 14. Michael Hill assumes that theEngadine building can be sold for $400,000 in the year 2029. At anypoint in time the resale value of the display cabinets is just$26,000. In ten years’ time Michael Hill assumes that it will havecash holdings of $4.4 million. You note the ATO regulation that allnon-current assets be depreciated to zero. 15. If the Engadinestore proceeds, then Michael Hill will implement a privateplacement to raise $800,000 from institutional investors to fundthe store. The CEO’s annual salary in 2018 is $1,511,738 and is notexpected to change whether the Engadine store opens or not. 16. Ifthe directors approve the Engadine store Michael Hill anticipatesthat it will require an additional $400,000 of inventory today ontop of the existing level of $1.5 million, and accounts payablewill increase by $270,000. The accounts receivable balance willincrease from the current level of $5.4 million to $6.2 million ifthe Engadine store proceeds. 17. Michael Hill has a required rateof return of 9%. Assume the company tax rate will remain at30%.