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Statement of the Problem

Considering the proposed addition of ShoeShock to the Shoe Division, should Mr.
Manlapig pursue its investment plans for ShoeShock production?

Identification of Critical Issues


1. The effects of purchasing the required machinery for the new product, ShoeShock,
and the additional costs for modifications it will incur.
2. The Group’s imposed 13%-target ROA versus the Division’s ability to meet this ROA,
with considerations on the effects on net income, asset base of the division, and the
overall profitability of the group.
3. The Company’s conservative debt ratio of 0.2.
4. The effects on the ROA, taxation, and financial statements for the next 2 years in
maximizing the service useful life of the equipment.

Discussion and Analysis


The Generics Group of Companies (Group) is operating a broad spectrum of
businesses, with a consolidated asset of over Php 1 billion, consolidated net income
of Php 75 million, and sales-to-asset ratio of 1.1. The group also sets a target ROA
common for all divisions.
Shoe Division, the newest addition to the Generics Group, has a total asset of Php 50
million, and contributes 10% to the Group’s consolidated net income. For the past 10
years, the company has been surpassing the ROA targets and has consistently bested
all other divisions. It has a conservative debt ratio of 0.2, and uses the straight-line
method for depreciating its fixed assets. All profits are taxed at 32%.
The Company is considering the procurement of the required machinery for the
production of a new product called ShoeShock, a major investment plan which will cost
about Php 12 million. Additional costs of Php 1 million will be incurred for modifications,
and another Php 2 million for maximizing efficiency. The machine was determined to
have a 10-year useful life without salvage value, and may probably only be used for
ShoeShock production. Interestingly, the Company’s average product life cycle is only
4 years.
Depreciating the machine using a straight-line method over 10 years with no salvage
value, the investment’s ROA is projected to be slightly higher than the current
company’s ROA from 14.95% to 15.17% after its first year of ShoeShock production.
However, the same period also projects increase in Sales-To-Asset ratio from 1.50 to
1.80. See the Attachment for the detailed calculations.
Looking into the four-year average product life cycle, ROA under this assumption will
decrease to 13.20% on its first year while doubling the same to 26.02% on the second
year. The Sales-to-Asset ratio is projected to be relatively higher than the 10-year
useful life assumptions at 1.86 and 2.37, respectively.
A 5%-gross profit difference is estimated between ShoeShock and other products. The
Shoe Division’s sales forecast for the next two years are at Php 90.3 million and Php
107.5 million, with ShoeShock’s contribution forecasted to be at Php 5.4 million and
Php 16.5 million, respectively.
In order for the company to maintain a conservative debt ratio of 0.2, it was assumed
that modification and efficiency improvement costs of Php 3 million will be included in
the projected current liabilities, and will be paid during the first year. Total liabilities for
Year 1 and Year 2 after ShoeShock production is based on the product of Total Assets
and Debt Ratio.

Alternative Courses of Action


1. Implementation of the project ShoeShock using the Company’s average product life
cycle of ten years.

This alternative will result to ROA ratios of 15.17% and 26.61% for the next two years,
which surpasses the Group’s target ROA of 13%. Though the Sales to Asset ratio are
slightly lower compared to having a 4-year product life cycle, still the projected ROA
will be higher compared to the current year which is only at 14.95%. All ratios measured
will be higher than the target ROA of 13%.

Depreciation expense will be maximized at the end of the machine’s useful life and
appropriate tax dues will also be applied.

2. Implementation of the project ShoeShock using the machine’s useful life of four years.

This will result to a ROA ratio of 13.20% (slightly higher than the Group’s target ROA)
on the first year and an increase to 26.02% on the second year. Depreciation expenses
are higher relative to the 10-year useful life assumption, making tax dues lesser.
However, at the end of four years when the machine is fully depreciated, the value of
the machine will be considered a sunk cost. If no new depreciable assets are acquired,
depreciation expense is expected to decrease resulting to a higher taxable profit.

3. Do not pursue investment on ShoeShock production.

Even without ShoeShock production, the company is still able to meet the Group’s
target ROA. However, there is a lost opportunity of more profitable operations.

Recommendations
We recommend alternative course action number 1. This alternative with its
corresponding assumptions will result to a higher sales-to-asset ratio and exceeding
the target ROA, while maintaining the Company’s conservative debt ratio. All the ratios
measured, which is relatively important to the company, is projected to be higher than
the Group’s target ROA.
ATTACHMENT – GENERICS GROUP OF COMPANIES’ PRO FORMA FINANCIAL STATEMENTS