Question

please give analyzed computational and descrptive response

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

Answer 1

a) Computing the assets: Inventory of 30 days on $3.5 mn annual sales with 70% gross profit margin provides a carrying value of inventory of $87,500 i.e. 30% on $3.5 mn for 30 days.

b) Computing the split of equity and debt: It is given that there are no other assets other than operational assets. As such it is assumed that Inventory is the only asset. $87500 is split between liabilities and equity in ration 2.5:1.

Equity component is 25000

Debt component is 62500

c) WACC is the proportional incremental cost. Cost of equity is 22% and cost of debt, net of tax (12% - 33% on 12%) = 8.04%. As such the WACC is 12.02%.

d) Incremental sales @ 15% on $3.5 mn = 525000. Incremental cost on holding up the inventory from 30 days to 50 days will be rate of WACC applied on incremental value of inventory. Incremental value of inventory for 50 days turnover holding = 167708. 12.02% WACC on 167708 is the incremental cost which is 20158.

e) Net EVA is computed by taking the operating profit of 40% on incremental revenue of 525000 which is 210000. Reduce the incremental cost to factor the higher inventory holding period of 20158. Net Profit before tax is expected 189842. Reduce tax of 33% or 62648 will provide a net return of 127194.

Commercial area should definitely aim to increase the sales as EVA is positive & expected to be yielding.