Case Study: Expansion and Risk at Hansson Private Label, Inc.

: Evaluating Investment in the Goliath Facility Final Project by Rodrigo Montechiari Companys Business Operations, Strategy and Past Performance HPL is a manufacturer of personal care products for retail partners. Its strategy has always been to focus on efficiency, cost control and customer relation to guarantee solid revenue grows until 2007. Expansions have always been carefully analyzed and the Company never worked below 60% capacity utilization. HPL has been able to grow its revenues to $ 681 million in 2007 accounting for 28% of national consumption but the Company is working close to maximum capacity. On the other way, its performance on units sold is growing only at 1% per year and, since capacity utilization averages 90%, there is no room for further increase in revenues if not through expansion to a new facility. The Business Opportunity Facing four years of low growth rates and fierce competition, HPL has the opportunity to expand its production and increase its margins by signing a 3 years term contract with its biggest Client on the personal care products line. The opportunity has its risks. An initial investment of USD 45 million will be necessary and the Client, who is already HPL biggest one, only commits to a 3 year term contract. In addition, the necessary investment would double HPL debit and significantly increase its financial leverage. Consequently, any financial distress form the client would seriously jeopardize HPLs financial stability. Project Forecasts A NPV analysis based on HPLs Manufacturing Manager and CFO has been performed Cash Flow The following projected cash flow has been assembled based on the available information.
Current Net Operating Profit After Tax Plus: Depreciation Less: Change in working capital Total future cash flows 2009 $2.854 $4.000 ($12.848) ($5.994) 2010 $4.161 $4.000 ($1.469) $6.693 2011 $4.987 $4.000 ($1.438) $7.549 2012 $6.064 $4.000 ($1.525) $8.539 2013 $6.973 $4.000 ($1.547) $9.427

($45.000)

Net Operating Profit After Tax Plus: Depreciation Less: Change in working capital Total future cash flows

2014 $8.150 $4.000 ($1.639) $10.511

2015 $8.442 $4.000 ($422) $12.020

2016 $8.737 $4.000 ($430) $12.307

2017 $9.035 $4.000 ($438) $12.597

2018 $9.336 $4.000 ($446) $12.889

Using the WACC of 9.38% associated to a Company with similar leverage, the NPV of the project is estimated in $ 11.373 million. O the same way, the associated Internal Rate of Return is 12.94%.

NPV Sensitivity to Price Variations A sensitive analysis to changes in prices was performed to assess the projects sensibility to price fluctuations. At an initial selling price of $ 1.90 per unit, the projected cash flow would be the following:
At $1.90 Net Operating Income Before Tax Net Operating Income Future Value of OCF Present Value of OCF Current 2009 $10.512 $6.307 ($3.970) ($3.630) 2010 $13.296 $7.977 $10.359 $8.658 2011 $15.298 $9.179 $11.585 $8.853 2012 $17.741 $10.645 $12.959 $9.054 2013 $19.929 $11.957 $14.244 $9.098

($45.000) ($45.000)

At $1.90 Net Operating Income Before Tax Net Operating Income Future Value of OCF Present Value of OCF

2014 $22.586 $13.551 $15.740 $9.192

2015 $23.253 $13.952 $17.485 $9.335

2016 $23.928 $14.357 $17.881 $8.728

2017 $24.612 $14.767 $18.283 $8.159

2018 $25.304 $15.182 $43.310 $17.671

It is worth notice that final WC in 2018 has been added to Future Value of OCF. Based on the new OCF, NPV would increase to $ 40.120 (253% variation) and new IRR would be 21.05% (63% variation). At an initial selling price of $ 2.00 per unit, the projected cash flow has shown even higher sensitivity with a $ 62.234 NPV (447% variation) and 26.69% IRR (106% variation).
At $2.00 Net Operating Income Before Tax Net Operating Income Future Value of OCF Present Value of OCF 2009 $14.939 $8.964 ($2.413) ($2.206) 2010 $18.188 $10.913 $13.179 $11.015 2011 $20.672 $12.403 $14.690 $11.226 2012 $23.614 $14.169 $16.359 $11.429 2013 $26.319 $15.791 $17.949 $11.465

($45.000) ($45.000)

At $2.00 Net Operating Income Before Tax Net Operating Income Future Value of OCF Present Value of OCF

2014 $29.511 $17.706 $19.762 $11.541

2015 $30.316 $18.190 $21.689 $11.580

2016 $31.133 $18.680 $22.169 $10.821

2017 $31.961 $19.177 $22.656 $10.111

2018 $32.800 $19.680 $49.633 $20.251

The sensitivity analysis has shown that the project is highly sensitive to price changes. Since price is exogenous to HPL, it represents higher risk to the project success. Computation Analysis Using the full project cycle as a basis for analysis has resulted in positive NPV and IRR above the applied discount rate. But the analysis does not factor a possible reduction of capacity utilization should the Client not extend the contract or HPL find alternative ways to keep production levels. In addition, Payback period on all scenarios occur after 2011, year that the Contract will expire. That is an additional risk since should HPL need to terminate the project, salvage value most likely would not be sufficient to cover initial investment and incurred expenses. To accept the Contract and execute the project HPL will need to develop an alternative strategy to: a) Secure demand to its production after 2011 b) Protect itself against price fluctuations

Since better quality products have already increased its acceptance in the market, a possible strategy would be to continue production after 2011 with a proprietary low-cost/good quality product to be distributed on other retailers. Also, it would be possible to offer production capability to high price brand owners to a lower production cost since the new plant would be already partly amortized. I.e., the better strategy to deal with risks inherent to the contract is diversification of brands. To illustrate the issue on capacity utilization, a sensitivity analysis projecting maximum capacity at 75% by 2012 has resulted in a $ 584 thousand NPV and 9.59% IRR. Based on that is safe to state that keeping production levels above the 75% mark is key to the project success. Capital Planning HPL has been able to reduce its Long Term Debt in 53.8% from 2003 to 2007 and is currently leveraged at 20.46% while average D/E for the Industry is 49.1% (see exhibit 1).

Exhibit 1 - Debit/Equity Ratio (D/E) 2003 2004 Owners Equity 204,00 220,40 Debit 91,60 82,80 D/E 44,90% 37,57%

2005 234,30 73,80 31,50%

2006 252,40 65,80 26,07%

2007 267,90 54,80 20,46%

Since the project would have to be fully funded via debit, HPL leverage would increase to 40.16% getting closer to industry average. Based on the information provided by the CFO, the new WACC would be calculated by: WACC = S/(S+B)*Rs + B/(S+B)*Rb*(1-t) where S is the weight of equity on total capital, B is the weight of debit on total capital Rs is the cost of equity, Rb is the cost of debit and t is the tax bracket. Using the average equity cost of 6.6% from 2003 to 2007, WACC = 0.791*6.6% + 0.209*7.75%*(1-0,4) = 6.19% Thus it is safe to conclude that the discount rate of 9.38% is indeed conservative and that financing the project via debit will bring further value to it by reducing HPLs WACC due to tax benefits. No further change to the organization policy would be necessary on that topic.