1 ESMBA06 Finance 5405 Financial Management. 2 Team 07 Sushil Bhattachan Christina Danver Ben Gumpert Adan Montoya Gurinder Virdi

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ESMBA06

Finance 5405

Financial Management

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Team 07

Sushil BhattachanChristina Danver

Ben GumpertAdan MontoyaGurinder Virdi

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IntroductionAssumptionsAnalysisConclusionsRecommendations

Case 7Make or Buy Analysis

Dixie Holdings

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I. Introduction

Company Overview

Current Situation

Analysis’ Objectives

Financial theory applied in case

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Company Overview

Dixie HoldingDixie AirDixie PropertiesDixie Support

Dixie Support provides support services to Holding, including print services

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Current Situation

Dixie Support not capable of accommodating printing needs of Holding

$830,000 in 2003 for commercial print services

$293,000 can be brought in-house

EBIT of $50,000 in 2004 and EBIT of $75,000 in 2005 in local commercial printing (external business)

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Analysis’ Objectives

Should Dixie Support outsource or expand print shop?

3 Alternatives for Dixie SupportClose print shop completely and use

outside vendors for all printing.Expand print shop and perform all

feasible printing in-house.Expand print shop as above and enter

commercial printing business.

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Financial Theory

Make vs. Buy AnalysisPurposeChoosing a discount rate (riskiness) or

cost of capital (CC)

Project financial indicatorsNPV (dollar contribution of project)IRR (expected rate of return)MIRR (forces reinvestment at cost of

capital)

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Financial Theory

Risk AssessmentSensitivity Analysis (used in this case)Scenario AnalysisMonte Carlo Simulation

Cash FlowsEstimatingDiscounting

Investment project vs. Borrowing projectDifferences

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II. Assumptions

3% annual inflation rate for vendor pricing

2% annual volume increase in printing needs

Supplies as % of billing (30%)

No additional maintenance costs for alternative 2 and 3

Marketing/Sales expenses for alternative 3 are included in EBIT

Five year analysis assumes no additional external factors other than specified

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III. Analysis

Overview

Summary of case information

Alternatives’ analysis

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Alternatives Overview

Alternative 1. Close the print shop completely and use outside vendors for all printing.

Alternative 2. Expand the print shop as envisioned to perform all feasible work in-house.

Alternative 3. Expand the print shop as in Alternative 2 to perform all feasible work in-house. In addition, the print shop will enter the commercial printing business.

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Case Information

GeneralCost of CapitalAssumptions

Current costs and values for alternatives 1, 2 and 3

New costs for alternatives 2 and 3

Incremental savings for alternatives 2 and 3

External Revenues for alternative 3

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Cost of capital (Given)

Dixie Holdings (Overall corporate) 10%

Dixie Support 8%

Dixie Properties 7%

Dixie Air 12%

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Case assumptions

Projected general inflation rate 3.0%

Projected printing volume increase 2.0%

Supplies as % of billing 30.0%

Tax rate 40.0%

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Current costs and values for alternatives 1, 2 and 3 – Yr (2003)

Annual lease costs $7,125

Annual utilities/insurance $2,400

Annual labor $50,000

Annual material costs $42,837

Annual depreciation exp $20,000

Market value of existing equipment $230,000

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New costs for Alt. 2 and 3 – Yr 2003

Incremental annual lease expense $13,125

Building remodeling $50,000

Equipment investment $212,600

Depreciation on new equipment $25,000

Added annual labor costs $90,016

Added annual utilities/insurance $3,600

Annual vehicle expense $2,060

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Incremental savings for alternatives 2 and 3 – Yr 2003

Graphics printing $118,839

Forms printing $174,540

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External Revenues for alternative 3

Pre-tax earnings for 2004 $50,000

Pre-tax earnings for 2005 $75,000

Revenue growth rate after 2005 5.0%

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Alternative 2

Risk AnalysisMost conservative alternativeExtension of work performed by the Dixie

Support subsidiaryControl in house

Cost of CapitalUse Dixie Support CC (8%)

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Alternative 2 – Cash flows

Capital Flows 2003 2004 2005 2006 2007 2008 Building remodeling $50,000 Equipment purchases 212,600 Total investment $262,600

Incremental Savings Graphics printing $124,852 $131,170 $137,807 $144,780 $152,106 Forms printing 183,371 192,650 202,398 212,640 223,399 Total savings $308,224 $323,820 $340,205 $357,419 $375,505

Incremental Costs Lease expense $6,000 $6,000 $6,000 $6,000 $6,000 Printing supplies 92,467 97,146 102,062 107,226 $112,651 Utilities 3,708 3,819 3,934 4,052 4,173 Labor 92,716 95,498 98,362 101,313 104,353 Depreciation 25,000 25,000 25,000 25,000 25,000 Vehicle expense 2,122 2,185 2,251 2,319 2,388 Total costs $6,000 $222,013 $229,648 $237,609 $245,910 $248,566 Revenues - Costs ($6,000) $86,211 $94,172 $102,596 $111,510 $126,939 Taxes (2,400) 34,484 37,669 41,038 44,604 50,776 After-tax op earnings ($3,600) $51,726 $56,503 $61,558 $66,906 $76,163Plus: Depreciation 25,000 25,000 25,000 25,000 25,000Net cash flow ($266,200) $76,726 $81,503 $86,558 $91,906 $101,163

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0

$77

1

$82

2

$87

3

($266)

Net cash flows (000s)

NPV = $80.

IRR = 18.3%.

MIRR = 13.8%.

8%4 5

$101$92

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Alternative 1 Risk Analysis

Second most conservative alternative. Higher risk than alternative 1

All work performed by vendorsNo control in house

Cost of CapitalPenalize the Dixie Support CC (8%) by 2% to incorporate

higher riskIt is a borrowing project. CC = 8% – 2% = 6%

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Capital Flows 2003 2004 2005 2006 2007 2008 Sale of equipment (net of taxes) $230,000

Incremental Savings Materials $45,005 $47,282 $49,674 $52,188 $54,828 Lease $7,125 7,125 7,125 7,125 7,125 Utilities 2,472 2,546 2,623 2,701 2,782 Labor 51,500 53,045 54,636 56,275 57,964 Total savings (net of taxes) $4,275 $63,661 $65,999 $68,435 $70,974 $69,345

Incremental Costs Vendor billing $150,015 $157,606 $165,581 $173,959 $182,762 Loss of depreciation 20,000 20,000 20,000 20,000 20,000 Total costs (net of taxes) $102,009 $106,564 $111,348 $116,376 $121,657

Net cash flow $234,275 ($38,348) ($40,565) ($42,914) ($45,402) ($52,312)

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0

($38)

1

($41)

2

($43)

3

$234


NPV = $51.

IRR = -2.3%.

MIRR = 11.3%.

6%4 5

($52)($45)

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Alternative 3 Risk Analysis

Least conservative alternative. Higher risk than alternatives 1 and 2 due to external cash flows

Extension of work performed by the Dixie Support subsidiary + commercial printing business

Some control in house

Printing Industry

USA LouisianaEBIT 5.3% 4.0%ROA 7.5% 5.1%

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Alternative 3

Cost of CapitalLower EBIT and ROA in LouisianaPenalize the Dixie Support CC (8%) by 3%

to incorporate higher risk for external cash flows

It is an investment project. CC = 8% + 3% = 11%

Use Dixie Support CC (8%) for internal cash flows

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2003 2004 2005 2006 2007 2008Internal work CF (Alternative 2) ($266,200) $76,726 $81,503 $86,558 $91,906 $101,163Pre-tax earnings on external work $50,000 $75,000 $78,750 $82,688 $86,822Taxes on external work 20,000 30,000 31,500 33,075 34,729 External work cash flow $30,000 $45,000 $47,250 $49,613 $52,093Net cash flow ($266,200) $106,726 $126,503 $133,808 $141,518 $153,257

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0

$30

1

$45

2

$47

3


NPV = $242. IRR = 37.6%. MIRR = 23.6%.

11%4 5

$53$50

0

$77

1

$82

2

$87

3

($266)

8%4 5

$101$92

0

$107

1

$127

2

$134

3

($266)

4 5

$153$142

Internal

External

Net

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Sensitivity Analysis - Overview

Most likely caseNPV and MIRR vs internal cost of capitalExternal CC = Internal CC + 3%

Worst caseNPV and MIRR vs internal cost of capitalExternal CC = Internal CC * 2

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Sensitivity Analysis – Most likely case

Alternative 1CC 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0%NPV $39,941 $45,549 $50,911 $56,040 $60,949 $65,650 $70,155 $74,473 $78,615 $82,590 $86,407IRR -2.0% -2.0% -2.0% -2.0% -2.0% -2.0% -2.0% -2.0% -2.0% -2.0% -2.0%MIRR 8.0% 9.6% 11.3% 13.0% 14.7% 16.4% 18.1% 19.8% 21.5% 23.3% 25.0%

Alternative 2CC 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0%NPV $121,590 $110,446 $99,790 $89,594 $79,835 $70,487 $61,529 $52,940 $44,700 $36,792 $29,199IRR 18.3% 18.3% 18.3% 18.3% 18.3% 18.3% 18.3% 18.3% 18.3% 18.3% 18.3%MIRR 12.1% 12.5% 13.0% 13.4% 13.8% 14.2% 14.7% 15.1% 15.5% 16.0% 16.4%

Alternative 3CC In-house 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0%CC External 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0% 16.0% 17.0%NPV $302,493 $286,233 $270,678 $255,789 $241,530 $227,867 $214,768 $202,204 $190,147 $178,570 $167,450IRR 37.6% 37.6% 37.6% 37.6% 37.6% 37.6% 37.6% 37.6% 37.6% 37.6% 37.6%MIRR 21.8% 22.2% 22.7% 23.1% 23.6% 24.0% 24.5% 24.9% 25.4% 25.9% 26.3%

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NPV vs CC

$0$50,000

$100,000$150,000$200,000$250,000$300,000$350,000

cost of capital

NP

V

Alternative 1

Alternative 2

Alternative 3

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MIRR vs CC

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0

%

11.0

%

12.0

%

13.0

%

14.0

%

cost of capital

MIR

R

Alternative 1

Alternative 2

Alternative 3

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Sensitivity Analysis – Worst case

Alternative 1CC 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0%NPV $39,941 $45,549 $50,911 $56,040 $60,949 $65,650 $70,155 $74,473 $78,615 $82,590 $86,407IRR -2.0% -2.0% -2.0% -2.0% -2.0% -2.0% -2.0% -2.0% -2.0% -2.0% -2.0%MIRR 8.0% 9.6% 11.3% 13.0% 14.7% 16.4% 18.1% 19.8% 21.5% 23.3% 25.0%

Alternative 2CC 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0%NPV $121,590 $110,446 $99,790 $89,594 $79,835 $70,487 $61,529 $52,940 $44,700 $36,792 $29,199IRR 18.3% 18.3% 18.3% 18.3% 18.3% 18.3% 18.3% 18.3% 18.3% 18.3% 18.3%MIRR 12.1% 12.5% 13.0% 13.4% 13.8% 14.2% 14.7% 15.1% 15.5% 16.0% 16.4%

Alternative 3CC In-house 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0%CC External 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0% 22.0% 24.0% 26.0% 28.0%NPV $297,377 $276,640 $257,169 $238,859 $221,613 $205,347 $189,983 $175,454 $161,696 $148,654 $136,276IRR 37.6% 37.6% 37.6% 37.6% 37.6% 37.6% 37.6% 37.6% 37.6% 37.6% 37.6%MIRR 21.8% 22.2% 22.7% 23.1% 23.6% 24.0% 24.5% 24.9% 25.4% 25.9% 26.3%

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NPV vs CC

$0$50,000

$100,000$150,000$200,000$250,000$300,000$350,000

cost of capital

NP

V

Alternative 1

Alternative 2

Alternative 3

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MIRR vs CC

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0

%

11.0

%

12.0

%

13.0

%

14.0

%

cost of capital

MIR

R

Alternative 1

Alternative 2

Alternative 3

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IV. Conclusions Summary

Alternative 3Higher NPV and MIRR under assumed conditions.Best alternative in sensitivity analysis. It has the higher NPV and MIRR

under different scenarios.

Alternatives 1 2 3 Cost of capital 6.0% 8.0% 8.0%

11.0% NPV $50,911 $79,835 $241,530 IRR -2.0% 18.3% 37.6% MIRR 11.3% 13.8% 23.6%

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Real world

Industry NameNumber of Firms Beta

Cost of Equity E/(D+E)

Std Dev in Stock

Cost of Debt Tax Rate

After-tax Cost of Debt D/(D+E)

Cost of Capital

Advertising 35 1.34 10.72% 78.62% 59.79% 5.75% 13.41% 4.98% 21.38% 9.49%

Bank 505 0.58 7.03% 56.70% 25.23% 5.00% 28.11% 3.59% 43.30% 5.54%

Computer Software/Svcs 400 1.83 13.07% 96.55% 83.99% 6.25% 9.95% 5.63% 3.45% 12.82%

Entertainment 95 1.27 10.35% 79.14% 52.99% 5.75% 17.16% 4.76% 20.86% 9.18%

Financial Services 232 0.89 8.52% 44.48% 49.78% 5.50% 19.49% 4.43% 55.52% 6.25%

Grocery 24 0.77 7.97% 57.13% 38.19% 5.25% 25.57% 3.91% 42.87% 6.23%

Homebuilding 35 0.88 8.51% 61.59% 39.11% 5.25% 26.29% 3.87% 38.41% 6.73%

Information Services 33 0.96 8.85% 91.18% 32.58% 5.25% 18.52% 4.28% 8.82% 8.45%

Medical Services 203 0.81 8.13% 82.65% 65.24% 6.25% 16.52% 5.22% 17.35% 7.63%

Newspaper 19 0.85 8.36% 86.43% 24.56% 4.75% 28.88% 3.38% 13.57% 7.68%

Oilfield Svcs/Equip. 88 0.9 8.61% 80.34% 47.22% 5.50% 19.29% 4.44% 19.66% 7.79%

Publishing/Printing 41 0.83 8.27% 82.67% 41.91% 5.50% 20.14% 4.39% 17.33% 7.60%

Retail Store 49 0.95 8.83% 84.23% 44.66% 5.50% 24.67% 4.14% 15.77% 8.09%

Securities Brokerage 26 1.31 10.59% 33.87% 35.89% 5.25% 21.28% 4.13% 66.13% 6.32%

Telecom. Services 146 1.27 10.38% 76.25% 77.70% 6.25% 13.42% 5.41% 23.75% 9.20%

Utility 5 0.84 8.30% 51.45% 30.96% 5.25% 16.68% 4.37% 48.55% 6.39%

Wireless Networking 63 2.32 15.43% 73.77% 89.61% 6.25% 4.26% 5.98% 26.23% 12.95%

Market 7133 0.91 8.64% 71.59% 60.55% 6.25% 16.70% 5.21% 28.41% 7.66%

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V. Recommendations

Alternative 3Expand the print shop as envisioned to perform

all feasible work in-house. In addition, the print shop will enter the commercial printing business.

NPV($241,530) and MIRR(23.6%)

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Centrally control printing contractsReduce the list of printing vendors from 9 to 2 Get better prices and payment conditions

Fiscal YearVendors 2002 2003 ChangeMercury $85,002.31 $7,727.86 -91%Universal Color Graphics $16,982.44 $12,588.00 -26%Crescent Press $9,300.00 $24,446.00 163%Southern Lousiana Printing $5,628.50 $711.94 -87%Pickett Press $3,526.14 $2,337.10 -34%Sir Speedy $1,962.58 $8,939.50 355%French Quarter Printing $85.46 $0.00 -C & S Printing $1,161.00 $0.00 -Metairie Printing Service $0.00 $75,292.83 +Total $123,648.43 $132,043.23 7%

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Improve assumptions by using industry or historic data

Expand cash flow analysis to more than 5 yearsPro: higher precision in our results if future

flows are know, otherwise it will increase uncertainty.

Con: more difficult to calculate results. Unlikely to change recommendation.

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Perform lease vs. buy analysisfor buildingfor equipment

Buy additional equipment to perform 100% of work in-house instead of90% of graphics printing25% of forms printing

Explore ways to reduce cost and improve productivityRecycling cartridges and paperPrint same colors in batch to reduce rollers’

wash-up charges

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Perform additional analysis as part of business plan for alternative 3Window of opportunityMarket environment (demand and supply)Competitor analysisMarket positioningRisk recognitionRisk reduction strategiesFinancial Plan

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Questions and Answers

Any questions

Documents

1 ESMBA06 Finance 5405 Financial Management. 2 Team 07 Sushil Bhattachan Christina Danver Ben Gumpert Adan Montoya Gurinder Virdi