Question

Hey guys, could you please helpwith the below case study.

1. The cash flows at thestart.

2. The cash flows over thelife.

3. The cash flows at theend.

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

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

shares are listed on theAustralian Securities Exchange (ASX). Michael Hill ownsand

operates approximately 300retail jewellery stores across Australia, New Zealandand

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

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

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

data analysis related to oneparticular planned new store in the southern Sydney suburbof

Engadine. However, the capitalexpenditure associated with the construction of a newstore

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

building the newstorea financialanalysis is needed to determine if it will contribute tothe

goal of creating wealth for itsshareholders.

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

senior management with youraptitude for financial analysis. This talent wasdeveloped

through the practice-orientedassignments that you completed at University. You recallhow

exciting it was learning aboutlisted companies by searching and reading announcements

made to the ASX. The ChiefFinancial Officer (CFO) has asked you to perform afinancial

analysis of the plannedEngadine store using a purpose-built preformatted EXCEL

spreadsheet. The CFO hassuggested you liaise with company employees from a varietyof

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

will also search through publicdocuments to identify some of the assumptions that willbe

required in your financialanalysis, and certain additional information. Your analysis willbe

provided to the Board ofDirectors who must approve substantial capitalexpenditures.

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

and the fixtures and fittingssuch as specialised jewellers’ equipment and displaycabinets.

The directors are accountableto the shareholders and so a financial analysis is necessaryto

be confident that theinvestment in the new Engadine store is justified. Thefollowing

paragraphs contain asubstantial amount of information that has been gathered fromacross

the business and it is your jobto determine which information is relevant to theanalysis.

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

Michael Hill has $7.2 millioncash and it plans to use $1.6 million of this amount to payfor

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

redundant jewellery equipmentmust be sold. The equipment had a total capital cost in2016

of $600,000 and for taxpurposes have a ten-year life. The equipment can be sold todayfor

$130,000 and Michael Hill willuse the sale proceeds to distribute a $130,000 dividend toits

shareholders today.

5. According to the InvestorPresentation Michael Hill recently completed a

comprehensive brand review torespond to a changing consumer landscape. This reviewcost

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

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

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

confident that the Engadinestore can achieve sales in the first year of operation thatare

similar to an ‘average’ MichaelHill Australian store. You read the Investor Presentationto

identify the following twofigures relevant to MICHAEL HILL AUSTRALIA for the year

ending Jun-18:

a) Revenue

b) Total stores open

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

7. Since Michael Hill plans tobuild the new store in the year 2019, for capitalbudgeting

purposes the first year ofrevenue is expected in 2020. However, the retail environmentis

very challenging as evidencedby the disappointing Australian same-store sales growthrate

stated in the InvestorPresentation. Therefore, you forecast that the Engadinestore’s

revenue in 2020 is equal to theaverage revenue figure per store for 2018 that youcalculated

in Paragraph 6 compounded bythe 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 Presentationstates the business has gross profit margins of

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

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

Management is confident thatwith rigorous cost control they will be able to containthe

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

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

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

Michael Hill performs alltraining in-house using a dedicated facility that was establishedin

2017. The facility has anannual budget of $655,000 and inducts new employees in allaspects

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

$75,000 per annum for stafftraining. However, the training division has sufficientspare

capacity to train the Engadinestore’s employees without the facility incurring anyadditional

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

expense to the Engadine storeeach year.

10. For taxation purposes thenew building has a twenty-year life. However, MichaelHill

will perform the financialanalysis of the Engadine store over a ten-year period. Thenew

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

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

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

management accountantsdepreciate all assets over an operational six-year life.

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

years developing a wedding ringsizing app. This project is still several years away fromfullscalerelease but toensure this expense generates the required returns the directorswant to

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

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

Michael Hill’s accountantconfirms that interest payments are classified as a businessexpense

and are therefore taxdeductible.

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

of advertising for the store’sopening in 2020. Because this expense will reduce thenew

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

out over the new store’sten-year useful life. The ATO states that expenses associatedwith

the Engadine store’s grandopening can be claimed as a business expense in the yearincurred.

Michael Hill’s totaladvertising budget for 2020 is $3.4 million and predicted toincrease by

$200,000 each year. If theEngadine store opens, the annual advertising budget willremain

unchanged. For cost accountingpurposes Michael Hill must allocate overheads acrosseach

business unit. Therefore, it isproposed that the Engadine store be assigned a fraction of1/171

of the total advertisingbudget.

14. Michael Hill assumes thatthe Engadine building can be sold for $400,000 in theyear

2029. At any point in time theresale value of the display cabinets is just $26,000. Inten

years’ time Michael Hillassumes that it will have cash holdings of $4.4 million. You notethe

ATO regulation that allnon-current assets be depreciated to zero.

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

to raise $800,000 frominstitutional investors to fund the store. The CEO’s annual salaryin

2018 is $1,511,738 and is notexpected to change whether the Engadine store opens ornot.

16.If the directorsapprove the Engadine store Michael Hill anticipates that it willrequire

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

accounts payable will increaseby $270,000. The accounts receivable balance willincrease

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

17.Michael Hill has arequired rate of return of 9%. Assume the company tax ratewill

remain at 30%.