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Case Study-"Accounting and finance for Managers"

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Mahatma Gandhi University provides "Accounting and finance for Managers" Case Study for MBA Program. …

Mahatma Gandhi University provides "Accounting and finance for Managers" Case Study for MBA Program.
http://www.mgu.edu.in/

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  • 1. Case Study 1: Red Berry Energy Limited Organization’s Overview Red Berry, based in India, focuses on providing the economical wind energy solutions that transform the kinetic energy of wind into electricity. Its clients comprise governments and corporations, such as utility organizations. Red Berry manufactures turbines and generators at its production centers in India, China, Germany, and the United States and provides repair and maintenance services. Red Berry's insistent extension strategy focuses on low-cost production and regional price prejudice. As the world’s third major wind-turbine producer with a market share of 10.7% worldwide and 60% in India, Red Berry extended its operations swiftly before the recession of 2008 by including suppliers in its supply chain. However, Red Berry has divested in some of its investments and reduced its debt burden. Issues before Red Berry In 2008, Red Berry’s clients in the United States and India complained that Red Berry's wind turbines cracked in high winds and failed to generate the power yields stated in sales contracts. Several clients terminated their orders from Red Berry because of some quality issues. The organization renovated 1,251 turbine blades for a total of $100 million to honor the warranty of its product in 2009. The faulty turbine blades not only proved costly to repair, but they also hampered the organization's goodwill. The disordered economic atmosphere and international credit crisis slowed down the growth of swiftly rising wind energy markets in different countries, such as U.S. and Europe. A Danish consulting organization anticipated that orders received by wind turbine producers dropped by 56% in the first half of 2009. However, the wind turbine market is improving, and as a result of this, the liquidity position of Red Berry's clients improves. In fact, the U.S. wind industry saw record growth in 2009 as it increased its power producing capacity by nearly 10,000 megawatts. The wind turbines were set up mainly due to encouragement from the American Recovery and Reinvestment Act of 2009. The total installed capacity in the U.S. is now over 35,000 MW. Wind power is a completely renewable source of energy, which generates less pollution. The advancement in technology has made it more viable to generate wind power. In addition, the rising prices of oil have made the wind power more financially attractive. It is important to note that an energy producing organization, such as Red Berry, is dependent on government subsidies to earn the revenue, given that oil, coal, and nuclear energy are cheaper energy sources. Red Berry has suffered losses for various quarters. Its net losses in the second quarter of the existing fiscal year amounted to ` 298 crores. Its revenue also decreased to ` 3875 crores, against ` 4,884 crores a year ago. However, Red Berry is looking to enlarge its profitability and has directed to secure several high profile contracts in 2011, such as 1,500 megawatt project from Orange Energy India. Case Studies
  • 2. Accounting and Finance for Managers Notes Mahatma Gandhi University Business and Financial Metrics Fiscal Quarter Ended March 2010 Red Berry's revenue declined to 22% for the quarter ended March 2010. Sales volume of Red Berry's business was reduced by 35% and became 740 MW due to order delays. In the U.S., order volume remained less due to low gas prices and low electricity demand. Red Berry expects the markets to recover by 2011 and 2012 because the government has provided investment tax credits. In Europe, the debt crisis has resulted in reducing energy subsidies and the amount available for project financing. Red Berry started manufacturing wind turbines particularly designed to work at low-wind speeds. First Quarter Fiscal 2010-2011 Results Throughout the first quarter of 2010-2011, Red Berry earned revenues of ` 3,499 crores. The organization's gross margin is stable at 40%. Red Berry reported a net loss of ` 813 crores due to low sales volumes and foreign exchange loss of ` 360 crores. Its total orders throughout the quarter were approximately $4.9 billion. It has also received orders from Indian organization for generating 670 MW power. Second Quarter Fiscal 2010-2011 Results During the second quarter of 2010, Red Berry accounted a net loss of ` 278.11 crores compared to a loss of ` 271.50 crores in the second quarter of 2009. The organization generated ` 4,632.03 crores revenue in the first quarter of 2010 as compared to ` 5,870.78 crores in the second quarter of 2009. About 95% of Red Berry's revenue was generated from its wind turbine generator business, whereas, the rest is generated from its gear box, foundry, and forging businesses. Globalization Strategy and Vertical Integration Red Berry is concentrating on globalization by using various methods. First, it gets advantage from India's depreciating currency, as its products become cheaper as compared to the products of other manufacturers. Second, Red Berry presents different sales packages in different countries. For example, in China, where prices are low, Red Berry provides full power plants, but in the U.S., Red Berry establishes cheaper turbine generators. This price discrimination facilitates Red Berry to reduce its costs and maximize its profit margin. Red Berry is raising its international reach with its Research and Development (R&D) branch in Europe. The organization is producing in India and China and focusing on top international wind energy markets. In 2004, 80% of Red Berry’s sales were in India; by 2007, international sales accounted for 62% of the total. Red Berry keeps on expanding its operations in new countries and maintaining its position in the existing market. For example, in January 2011, Red Berry received its first order from Trivets, a Swedish wind power manufacturer. The Swedish organization ordered two 3.2 MW wind turbines. In addition, as of November 2011, Red Berry campaigns to set up offices in several Latin American countries, including Mexico, Argentina, and Chile. Although Red Berry is growing globally, it is still focusing on expanding its operations in India. For example, in January 2012, the organization proclaimed an order for 1,200 MW of wind turbines of value $2.18 billion from Caper Energy India. It has also received one big order from Veda and many other orders from India. Acquisitions and Divestitures Prior to the recession in 2008, Red Berry insistently pursued an acquisition strategy to remove minor competitors. For example, in July 2006, Red Berry acquired the German wind turbine developer, XYZ Power, for $2.8 billion (USD) to decrease competition and obtain new product lines. XYZ Power captured 9% market share in Germany and provided Red Berry a strong grip in the Western European market.
  • 3. Case Studies Notes CASE STUDIES Mahatma Gandhi University Still, a destabilized U.S. wind turbine market has made Red Berry managers to re-evaluate its expansion strategy. Red Berry sold 34% holding in a subsidiary, Wisdom Transmissions, for $480 million, in its efforts to decrease debt. After selling Wisdom Transmissions, Red Berry's stake in the gear box maker declined to 34% from 59%. Red Berry purchased the Belgium-based Wisdom in 2005 for $668 million. Red Berry remained burdened with debt as a result of its quick expansion strategy. The organization raised debt in 2006 to acquire XYZ Power for $2.8 billion and construct new factories in the U.S., China, and India. Credit Rating Information Services of India anticipated that $3.3 billion of net debt was raised by Red Berry in 2008 and it was 1.6 times of its equity at that time. In November 2010, though, Red Berry repaid its debt of $680 million, which it raised for acquiring Wisdom Transmission. After that, it again raised a new six-year loan of $465 million from the State Bank of India. At this time, Red Berry's net debt was lowered by $360 million, and its total debt has been decreased by 16%. Its debt-to-equity ratio was still high at 1.1. As Red Berry kept on reducing its debt, its interest payments also declined. The 2008 Financial Recession has Slowed Down the Growth of Wind Energy Sector in 2009 Although there was swift development in the wind energy sector in 2008, the unstable economic environment and international credit crisis have led some of the fast growing markets, such as U.S. and Europe, sluggish in terms of new capacity additions. For example, Emerging Energy Research estimates that new wind plant activations in Europe in 2009 could drop by as much as 18% as compared to 2008. Europe was expected to add 7,836 MW of wind power capacity in 2009, down from 9,556 MW in 2008. The credit crisis has also decreased the number of wind projects in the United Kingdom, Italy, and France. According to the Danish consulting organization, MADE, the wind turbine manufacturers reported a 52% drop in orders in the first half of 2009. In response of falling demand, Red Berry reduced its work force from 290 to 80 at its Minnesota plant in 2009, which has the ability to manufacture 300 turbines per year. However, analysts anticipated demand to rise in the fourth quarter of 2009. Red Berry anticipates to sell equipment capable of producing 2,700 MW of electricity in the year ending March 31, 2011, down from 2,890 MW installed in the preceding year. Government Restrictions on Foreign Wind Turbine Suppliers in China Public sector utilities in China have shown a preference for buying wind turbines from low-cost, local manufacturers. There are three leaders in turbine production in China, and 60 smaller companies. Foreign companies like Red Berry have been losing market share in China, which is now the world's largest for wind turbines after several years of nearly 80% annual growth. Chinese manufacturers, which are generally less technologically sophisticated than those of foreign companies, sell turbines for about 5% less than those made by Red Berry, but as much as 20% below those of other foreign companies. Some Chinese localization rules like those at the largest wind farm in the world in Rudong, China, prevent non-Chinese manufacturers from selling turbines. These rules require 70% of turbine equipment to be sourced and built domestically. The Chinese government has also sought to eliminate turbines with capacities of less than one megawatt, a policy which is favorable to domestic Chinese turbine manufacturers. China's National Energy Administration predicted that China's wind power capacity is likely to rise from 12,000 megawatts at the end of 2008 to 30,000 megawatts by the end of 2011, a goal that will require about 100 billion yuan ($14.6 billion) in investment. However, unfavorable policies for foreign turbine manufacturers in China put companies like Red Berry at a disadvantage and weaken their foothold in one of the most promising wind markets in the world. Despite China's stringent policies regarding sourcing of wind turbines, it still represents a market with the most growth potential in the world. China relies on coal to generate about 70 percent of electric power. The country is expected to have 120 million to 150 million kilowatts of installed wind power capacity, totaling 7 to 9 percent of the national total installed electricity capacity, in
  • 4. Accounting and Finance for Managers Notes Mahatma Gandhi University 2020, according to the China Energy and Environment Technology Association. This represents an enormous investment opportunity for wind turbine manufacturers such as Red Berry. Government Regulation of Energy Markets Clean energy companies are highly dependent on government subsidies and support to bring in revenue, given that oil, coal, and nuclear energy are cheaper, well-established energy sources and hold oligopolistic control over the world-wide energy market. Given this dependence on the government, many environmental and social movements are focusing on pressuring the government to pave the way for a transition to renewables. Furthermore, many governments endorse local renewables as an alternative to foreign fossil fuels, in an attempt to create energy independence. Government support of renewables is taking place at local, national, and global scales. One significant example is that in September 2009, the U.S. government announced it had awarded more than $500 million in grants to help finance wind projects under a $787 billion stimulus package designed to help revive the economy. The Kyoto Protocol The Kyoto Protocol is an international agreement to reduce greenhouse gas emissions in a global effort to stop climate change. The Kyoto Protocol mandates emissions caps through cap-and-trade systems of trading carbon credit. This system has the potential to benefit Red Berry as many countries make the transition to renewable energy such as wind power. The U.S. has not ratified the treaty and has no plans to do so. China, while part of the treaty, is classified as a developing country and therefore has no obligation to lower its emissions. Domestic Legislation Given the fear of global warming and pollution, which has led to increasing social support for clean energy sources, governments around the world have implemented legislation that indirectly leads to increased revenues for Red Berry. Examples include:  California has mandated that 25% of electricity come from clean sources by 2020 and 75% by 2050  The Obama administration authorized $100 billion of spending and tax breaks for green projects by signing the stimulus package into law  The Renewable Energy Standard bill, which would require utilities to generate 6% of their energy from renewables by 2012 and 25% by 2025, is being considered at the committee stage in the Unit States Congress  The European Union aims to get 22% of its energy from clean sources by 2010  China's Renewable Energy Law raises the target for the total percentage of renewable energy used in the country to 10% by 2020  In February 2009, President Obama extended tax credits for wind and increased the amount the government will spend on those credits by 30 percent. Obama said he would invest $15 billion a year in renewable energy sources to create five million new energy jobs through 2018. Legislative mandates like these benefit renewable energy companies because they force utilities companies to turn to other power sources, allowing companies like Red Berry to enter a crowded energy market. Also, such legislation usually leads to government support for renewable energy companies in the form of fiscal incentives. Questions: Q1. What were the main reasons behind the problem of Red Berry? Ans. The main reasons behind the problem of Red Berry were as follows:  Occurrence of global economic recession  Increase in the debt to finance acquisitions
  • 5. Case Studies Notes CASE STUDIES Mahatma Gandhi University  Unbalanced debt-equity ratio  Restrictions imposed by the Chinese government on foreign wind energy organizations  Reduction in subsidies to energy producing organizations in Europe  Production of defective turbine blades Q2. What steps should have taken by Red Berry during recession? Ans. The following steps should have been taken by Red Berry during recession:  Decreasing debt and raising funds by using equity shares  Avoiding any expansion by the way of any acquisition  Manufacturing quality products to enhance position in the market  Making economically feasible projects that could be implemented in different countries  Requesting the Indian government to provide more subsidies Q3. What were the main threats and opportunities before Red Berry? Ans. The main threats before Red Berry were as follows:  Global financial recession of 2008  Increasing competition in the international market  Decreasing subsidies that were the main source of profit The main opportunities before Red Berry were as follows:  Increasing the concern of world towards clean energy  Development of the Indian economy  Funds provided by the Obama administration Case study 2: BSL Company Ltd. Incorporated under the provision of Companies Act., 1956, BSL is engaged in manufacturing different types of ceramic tiles. The company operates in the oligopolistic market and has several branches across the country. In addition, it has a modern foundry located in Orissa. BSL purchases raw materials from different suppliers and plans to take up a new project to manufacture vitrified tiles. The new project would last for eight years and would be completed in three stages. The life cycle of the new project is shown in the following figure: Years Stage-1 Actual Production Efficiency Expected Production Efficiency 1 Activities in stage 1 Infrastructure development and commencement of commercial production 100% 75% Stage-2 2 Activities in stage 2 Commercial production reaches its peak 100% 85% 3 Commercial production 100% 95%
  • 6. Accounting and Finance for Managers Notes Mahatma Gandhi University continues Stage-3 4 Activities in stage 3 Commercial production continues 100% 95% 5 Commercial production continues 100% 95% 6 Commercial production continues 100% 95% 7 Commercial production continues 100% 95% 8 Commercial production continues 100% 95% In the new project, fixed investment would be ` 1200 million and working capital would be 20% of sales. Stage 1 would require ` 700 millions for fixed investments. The company would use various sources to finance stage 1. It would use retained earnings of ` 200 million and issue preference shares carrying dividend of 15% (redemption 6 years) to raise ` 150 million. In addition, the company would raise long-term loans @ 14% to finance rest of the amount (` 350 million). Stage 2 would require ` 500 million for fixed investments, which would be financed through raising loans and issuing rights shares (15 million shares for `20 each). The stage 3 would continue without further fixed investment. A proportion of working capital would be financed through long-term loans at 25% rate of interest and the remaining proportion would be financed through short-term borrowings from banks at the rate of 13% in all the three stages. Cost and other expenditures incurred in the different stages are shown in the following table: Stage-1 Stage-2 Stage-3 Fixed Cost 200 Millions 200 Millions 260 Millions Variable Cost 50% of sales 65% of sales 70% of sales Tax rate 30% 30% 30% Depreciation on fixed capital 15% 15% 15% After eight years, the project would be sold to fetch salvage value of ` 150 millions. It is important to note that all the long-term and short-term loans would have a zero period of 1 year and they need to be repaid in 5 equal installments. The company is also planning to modernize its manufacturing process by acquiring new machines for reducing operational cost and increasing profit. It invites tenders for the procurement of new machines and the tender goes to those manufacturers who supply quality machines at low prices. The new machines cost ` 200000 and have a useful life of 5 years after which it would fetch a net salvage value of `30000. The new machines would also decrease working capital requirement by `10000. The old machines have a book value of ` 50000 and market value of ` 40000. These machines can fetch a net salvage value of ` 1000 after 5 years. The new machines would save power cost by ` 5000 per year. Question for Discussion: Q1. Calculate the cash flow from the prospective of project manager and shareholders.
  • 7. Case Studies Notes CASE STUDIES Mahatma Gandhi University Ans. The calculation of project cash flow from the prospective of project manager is as follows: Year 0 1 2 3 4 5 6 7 8 Intial Outlay -850 -20 -640 -16 -16 0 0 0 0 Operating Cash Flow 112.5 145.1 268.6 276.9 287.4 280.1 274.2 269.6 Terminal Cash Flow 492 Project Cash Flow -850 92.5 -495 252.6 260.9 287.4 280.1 274.2 761.6 Fixed Investment -700 - -500 - - - - - - Working Capital -150 -20 -140 -16 -16 - - - - Initial Outlay -850 -20 -640 -16 -16 0 0 0 0 Revenue (1) 750 850 950 950 950 950 950 950 Revenue (2) - - 600 680 760 760 760 760 Variable Cost 487.5 552.5 1008 1060 1112 1112 1112 1112 Fixed Cost 150 150 240 240 240 240 240 240 Depreciation(1) 140 112 89.60 71.68 57.34 45.88 36.70 29.36 Depreciation(2) - - 100.00 80 64 51.2 40.96 32.77 EBT -27.5 35.5 112.9 178.8 237.2 261.4 280.8 296.4 Tax 2.4 33.9 53.6 71.1 78.4 84.3 88.9 EAT -27.5 33.1 79.03 125.17 166.01 183.00 196.59 207.46 Operating Cash Flow 112.5 145.1 268.63 276.85 287.35 280.07 274.25 269.59 Salvage Value - - - - - - - - 150 Working Capital - - - - - - - - 342 Terminal Cash Flow - - - - - - - - 492 The calculation of cash flow from the perspective of shareholders is as follows: Year 0 1 2 3 4 5 6 7 8 Initial Investment -200 - -300 - - - - - - Operating Cash Flow 21 53.4 174.3 216.8 223.4 257.7 251.8 269.6 Repayment Cash Flow -80 -80 -128 -128 -128 -198 -68 Terminal Cash Flow 240 Project Cash Flow -200 21 -327 94.3 88.84 95.38 129.7 53.75 441.6 The operating cash flow chart is prepared as follows:
  • 8. Accounting and Finance for Managers Notes Mahatma Gandhi University Year 0 1 2 3 4 5 6 7 8 1 Revenue (1) 750 850 950 950 950 950 950 950 2 Revenue (2) - - 600 680 760 760 760 760 3 Variable Cost 487.5 552.5 1008 1060 1112 1112 1112 1112 4 Fixed Cost 150 150 240 240 240 240 240 240 5 Depreciation(1) 140 112 89.60 71.68 57.34 45.88 36.70 29.36 6 Depreciation(2) - - 100.00 80 64 51.2 40.96 32.77 7 Interest (TL 1) 56 56 44.8 33.6 22.4 11.2 0 0 8 Interest (TL 2) - - 33.60 26.88 20.16 13.44 6.72 0 9 Interest (STL) 13 15.6 27.30 30.68 32.86 32.86 32.86 32.86 10 EBT -96.5 -36.1 7.20 87.66 161.74 261.4 280.8 296.4 11 Tax - - - - 37.2 78.4 84.3 88.9 12 EAT -96.5 -36.1 7.20 87.66 124.54 183.00 196.59 207.46 13 Pref. Div. 22.5 22.5 22.5 22.5 22.5 22.5 22.5 0 14 OCF - 21 53.4 174.30 216.84 223.38 257.57 251.75 269.59 Working Notes: 1. Total working capital requirement for stage 1 at 100% efficiency is 20% of 1000 lacs = `200 lacs Margin required working capital is as follows= 25% of Rs 200lacs = ` 50 lacs Total long-term funds needed for stage 1 = fixed investment + margin money = ` 750 lacs Retained earnings = `200 lacs Preference shares = ` 150 lacs Long-term loans = ` 400 lacs Similar calculations are performed for stage II and loan amount for stage II is ` 240 lacs. Rest of the working capital is funded through short-term funds. 0 1 2 3 4 5 6 7 8 Loan Stage I 400 400 400 320 240 160 80 Repayment I - - 80 80 80 80 80 Interest I - 56 56 44.8 33.6 22.4 11.2 Loan II - - 240 240 240 192 144 96 48 Repayment II - - - - 48 48 48 48 48 Interest II 33.6 26.88 20.16 13.44 6.72 Working Capital 150 170 310 326 342 342 342 342 Margin 50 50 50 90 90 90 90 90 90 Short Term Loan 100 120 220 236 252 252 252 252 Interest (STL) 13 15.6 28.6 30.68 32.76 32.76 32.76 32.76 2. Tax is not payable in first 3 years due to losses. Tax is only payable after writing off accumulated losses in the fourth year of operations from the profit left after writing off carry forward losses. 3. Preference shares are redeemed at par in the 7th year.
  • 9. Case Studies Notes CASE STUDIES Mahatma Gandhi University Q2. Determine the project cash flows of replacement project if depreciation rate is 25% and applicable tax rate is 30%. Ans. The project cash flows of replacement project is as follows: 0 1 2 3 4 5 Initial Outlay -150000 - - - - - Operating Cash Flow - 47650 44838 42728 41146 39960 terminal Cash Flow - - - - - 8000 Project Cash Flow -150000 47650 44838 42728 41146 47960 Change in FI -160000 - - - - - Change in WC 10000 - - - - - Initial Outlay -150000 - - - - - change in EBIT - 52000 52000 52000 52000 52000 Change in Depreciation - 37500 28125 21094 15820 11865 Change in EBT - 14500 23875 30906 36180 40135 Change in tax - 4350 7163 9272 10854 12040 Change in EAT - 10150 16713 21634 25326 28094 Operating Cash Flow - 47650 44838 42728 41146 39960 Change in Salvage Value - - - - - 18000 Change in WC - - - - - -10000 Terminal Cash Flow - - - - - 8000 Working Notes: Initial outlay is ` 200000 minus ` 40000 (present market value of old machines) Working capital is going to decrease with the procurement of new machines Savings of ` 52000 per year is considered as increase in Earning Before Interest and Tax (EBIT) Depreciation is calculated on incremental book value (200000 – 50000) Change in salvage value is the increase in salvage value of new machines over old machines after 5 years Change in working capital in terminal cash flow is considered outflow of cash

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