Rob’s Furniture Restoration Ltd (RFR) is a family-owned furniture restoration business located in Hornsby. Rob started the company in 2006, with his wife Meredith. They each own 35% of RFR’s shares, with the balance owned by Rob’s sister, Sarah. The company’s Board of Directors consists of Rob, who is the Managing Director, Meredith and Sarah, who is the Company Secretary. Sarah is also RFR’s Accountant and Office Manager.
The last few years have been challenging for RFR, due to increased competition from large international furniture manufacturers. The company has survived by focusing on producing high quality custom furniture. In doing so, it has established a reputation for craftsmanship and quality finishes.
RFR currently operates from a factory in Hornsby that it has owned since incorporation. It rents additional space in Asquith for $85,000 p.a. The company is currently considering a proposal to increase the scale of its operations. This would involve the sale its Hornsby property, as well as the cancellation of the lease on its Asquith property and the purchase of a larger property in Mount Colah, where it would locate its expanded operations. By cancelling the Asquith lease, RFR would incur in a tax-deductible $7,000 cancellation fee.
Moving to the new property would likely increase RFR’s annual maintenance costs from $4,800 to $11,500. Those costs are expected to increase by 2% p.a. over the next five years, irrespective of whether RFR goes ahead with the proposed expansion. The schedule of expected maintenance costs associated with the proposal are shown in the Appendix (the 2% annual increase is included in those estimates).
Rob and Meredith have asked Sarah to investigate the financial viability of the proposed expansion. They recently returned from an overseas trip (part work and part holiday), during which they met the Managing Director of Omod Group, a large international furniture manufacturer, with the intention of negotiating an exclusive contract to repair the furniture produced by Omod’s Australian operations. The trip cost $37,500 in airfare, accommodation and meals. Since most of it was business related, RFR reimbursed Rob and Meredith for $21,500 of the expenses they incurred.
Upon their return, Rob and Meredith met with Sarah to explain that if RFR expanded its operations, it could enter into a lucrative service and repair contract with Omod. They believe that by purchasing new production equipment and increasing the size of RFR’s facilities, it could expand its operations sufficiently to become the sole repairer for all
Omod’s Australian furniture. However, this would mean that RFR had to consolidate its operations at the new premises in Mount Colah.
Rob and Meredith believe that RFR would be able to take on this expansion without a negative effect on the quality of the products it provides to its existing clients. Rob provided revenue forecasts based on the proposed expansion, as detailed in the Appendix. He also outlined some preliminary estimates of the costs involved. The new premises would cost about $2,430,000 to purchase. Another large cost would be the new equipment RFR would have to purchase for the increased quantity of work resulting from a deal with Omod. They received a reliable quote of $260,000 for this equipment.
Rob is very excited and believes that RFR could double its revenues in the next three years, if it goes ahead with the relocation and expansion. Sarah thinks the company is already profitable enough and provides a good return on investment, and that a larger volume of business could create difficulties. She also believes that Rob and Meredith have not considered the additional staff that would be needed if RFR goes ahead with the proposal. She anticipates that three new workers would be required, and that all the company’s workers (the three new people and the existing four) would need special training on the new equipment. This training would cost $8,000 per person and would have to be undertaken before the equipment could be used. The new staff wages would be $74,700 p.a. each, in line with the current staff wages. Furthermore, an allowance must be made for all wages to increase at 2.5% p.a. Details of the estimated wages are shown in the Appendix (the 2.5% annual increase is included in those estimates).
Another firm recently offered RFR $1,085,000 for the property in Hornsby. Sarah believes this is a good offer, which RFR should accept if it decides to relocate to Mount Colah. Selling the Hornsby property would have no tax implications.
Meredith is worried about the amount of capital required for the proposed consolidation and expansion. RFR certainly does not have any spare cash. The company borrowed money for recent renovations and is still making payments on the resulting term loan from the bank. In the current climate, she is concerned that additional financing would be hard to get. She feels that a thorough business plan and report should be submitted to the board members, so that an informed decision can be made. Rob and Meredith agree that Sarah has the skills to assemble the necessary data and write the report.
A summary of the data Sarah gathered is presented below:
1. It was agreed that the sales figures presented by Rob in the Appendix would be used in the analysis. However, Sarah is concerned that Rob’s revenue projections are too optimistic.
2. The tax office has agreed that the $8,000 training fee per staff member would be a tax deduction at the time of payment, although Sarah says the company has the option to spread this expense over ten years for accounting purposes. 3. Sarah informed Rob that there is old unused equipment at the current premises that could be used for the proposed expansion. Although it is fully depreciated, it was recently appraised for insurance purposes and has a market value of $18,000. 4. Sarah analysed RFR’s cash flows and found that it would need to borrow $2,500,000 to finance the proposed relocation and expansion. RFR’s bank has given preliminary approval for this loan, but wants to see the final business plan. The interest rate for the loan would be 5.25% p.a., compounding monthly, and it would be repayable over 10 years. 5. RFR pays tax at the corporate tax rate of 30%. 6. Sarah believes that RFR’s current weighted average cost of capital of 11% is appropriate for the analysis of the proposed expansion. 7. Inflation is already included in all forecasted cash flows. 8. Land is not depreciable and no capital gains tax applies to it. In five years it is estimated that the new premises at Mount Colah would be worth about $4,250,000. 9. The Tax Office has determined that the building at the Mount Colah premises, which is valued at $950,000, could be depreciated at 7% p.a., while new the equipment could be depreciated at 20% p.a. 10. In five years the new equipment would have a scrap value of $75,000, while the old reused equipment would have no value. 11. There would be an increase in inventory of common spare parts, estimated to be 6% of the following years’ revenue, each year, if RFR goes ahead with the expansion.
You have been asked to assist Sarah to produce the following:
1. A one-page executive summary with a recommendation to RFR’s directors on whether it should expand its business, as outlined above. It should provide reasons for the recommendation and a summary of the financial analysis conducted. 2. Readable Excel spreadsheets showing the NPV calculations for the project, as well as all other calculations used to support your decision.