Baldwin Bicycle Company (Baldwin or the Company), a small “mid-market” bicycle manufacturer, had a “private label” opportunity with Hi- Valu Stores, Inc. ( Hi- Valu), which operated discount department chain stores in the Northwest. Baldwin had to make a decision whether to accept the Hi-Valu’s Challenger deal or not. To make an informed decision, the company should exam a blending of financial, marketing, and strategic implications of the Challenger deal.
Financial analysis
current financial situation
With an annual ROA of 3.15% in 1988, Baldwin’s current financial situation is not favorable at all (see exhibit 3 for ratio analysis).
First of all, the company had poor assets management. The high inventories and accounts receivables, which account for 62% and 31% respectively of total current assets, substantially impair the financial liquidity (see exhibit 4 -balance sheet).
As the cash ratio is merely 9.83% (see exhibit 3), the company is extremely short of cash flow and at the danger of illiquidity. The low inventory turnover of 2.9 times per year signals that the company should take measure to improve its asset management (see exhibit 3).
Furthermore, the company is facing a high risk of insolvency in the future due to its highly leveraged financing. The high Debt to Equity ratio of 1.6 may be a barrier for further financing at a reasonable cost (see exhibit 3).
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Besides, the company’s profitability is not promising at all. The annual return on sales of 2.49% provides the company little room for growing (see exhibit 3).
Return on equity, driven by the low asset turnover, low return on sales and high D/E ratio, is shabby compared to the cost of funds.
Challenger deal profit analysis (see exhibit 1)
The Challenger deal will bring an additional $577,250 contribution margin to Baldwin. Selling at $92.29/unit, the Challenger bicycle has unit contribution margin of $23.09 ($92.29 per unit price less $69.2 per unit variable cost).
The relevant costs of manufacturing a Challenger bike include materials, direct labor and variable overhead, which totals $69.2 for each bicycle. The fixed overhead costs are irrelevant to the decision making, as they will occur in any case.
However, the Challenger deal will erode 3000 units’ sales of bike through the regular distribution channel. As per unit contribution margin for regular sales is $43.32 ($110.05 per unit price less $66.73 per unit variable cost), the total impact of the cannibalization will be $129,960 for the 3000 bikes. Nevertheless, it’s arguable that the 3000 units’ of cannibalization will eventually occur no matter Baldwin takes Challenger deal or not, if Hi-Valu enters the private label bicycle business anyway. In that case, the lost contribution margin, although it may very well occur, will not be a relevant cost of accepting the Challenger offer.
Besides, an incremental asset related cost of $143,322 will incur for carrying the added working capital involved in the Challenger deal. To meet the increased annual production, Baldwin should invest at least 685,511 in working capital including such as inventories and accounts receivable. Excluding the reduced assets due to cannibalization, the company’s accounts receivable will increase 11% and inventories will increase 19%, which add $143,322.42 asset carrying cost annually. In addition, there will be a one time cost of $5000 for preparing drawings and arranging sources. Fortunately, adding the Challenger line will not incur any capital investment for additional capacity since the company’s current capacity is still sufficient for the 122,000 units’ annual production.
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Putting all the relevant cost and benefit related to the Challenger deal together, the company could expect $298,968 incremental pre-tax profit and $161,177.03 after tax profit from the Challenger deal. For purely profit maximization purpose, the deal is attractive. The return on investment of the Challenger deal is 23.5% (=161,177.03/685,511.03), twice as much as the cost of financing receivables and inventories (11.5%).
Challenger deal cash flow analysis
As analyzed above, to earn the additional $161,177.03 profit from the Challenger contract, the company should invest at least $685,511.03 in working capital to execute the Hi-Valu contract. If the company can’t get any current debt or trade payable financing, the operational cash flow will slip more than 500,000. The company’s current cash of 342,000 is not enough to cover this and external debt or equity financing is needed to support the new business.
Impact of Challenger deal on ROA and ROE
The impact of Challenger deal on Return on Equity and Return on Asset is impressive, which will increase from 8.11% to 12.30% and from 3.15% to 4.73% respectively (see exhibit 3).
The more than 50% improvement for both ratios is driven by the increased Return on Sales and Assets Turnover. By capitalizing the excess capacity, the Challenger deal will generate substantial contribution margin to cover the fixed costs, which push the Return on Sales to increase from 2.49% to 3.35%, an impressive 35% improvement from 1988’s number. In addition, average accounts receivable (A/R) turnover could have a slightly improvement. Compared to 1988’s A/R turnover of 8 times per year, the Challenger contract’s A/R turnover is 12 times per year, which will help to increase the weighted average A/R turnover to 8.8 times per year.
Risk analysis
Financial risk
Although the Challenger deal will bring attractive profit, Baldwin may have financial troubles to execute its responsibilities to Hi-Valu contract. First, the company will face a cash flow constraint if it can’t successfully get enough funds to finance the $685,511.03 investment in working capital. While the additional funding is not impossible, with an already high Debt to Equity ratio, the company would bear a high cost for debt or equity financing, aggravating the potential insolvency.
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Further, unless the company can finance part of the new business through account payables and other current liabilities, the abrupt slip in operational cash flow due to investment in working capital will negatively influence external investors or/and analysts’ opinions and bring vicious circle effect to future financing.
Marketing Risk
Taking the Challenger offer, Baldwin may offend existing dealers and retailers because the company charges a lower margin from Hi-Valu. Currently most of Baldwin’s sales were through independently owned toy stores and bicycle shops at higher prices than Challenger’s. Thus the existing relationships may suffer when the company selling the similar product at two different prices in two different sales channels. If the existing distributors also want the Challenger products, or the Challenger prices, Baldwin will face the risk of either eroding regular sales or losing existing distributors. Both of the risks are critical to Baldwin’s strategic positioning.
Operational Risk
As the 22,000 (25,000 less 3,000 lost) additional units will push Baldwin to over 90% capacity, the company may face the risk of over-capacity if the regular business recovers in the future. In that case, to meet the operational efficiency, the company has to either invest more capital in capacity or forgo the market upturn opportunity. Either of them makes Challenger deal unnecessary, because the former will add paramount financial burden while the latter will induce more opportunity cost than Challenger’s profit.
In addition, the 90% capacity utilization is high enough to cause operational distress. Queuing problem may occur due to the volatility of incoming orders. This will increase the risk of stock out and damage the company’s reputation.
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Recommendation
Given Baldwin’s current poor performance, the Hi-Valu offer is tempting. But it could be disastrous in the long run if the risk factors identified above turn the wrong way. To avoid being fascinated merely by the short run profit, Baldwin would better first conduct a thorough demand forecast and then negotiate a better deal with Hi-Valu before accepting the offer. Unless the terms of Hi-valu deal can be improved significantly, Baldwin should stick to its existing business and try to decrease costs and improve assets management and turnover.
Thorough market demand forecast
As a market upturn in the future will make the Challenger deal unnecessary, an accurate market demand forecast is extremely important for making the new business decision. Before investing substantially in this business opportunity, the company will be better off if it invests in market data collection and analysis.
Negotiate a better deal with Hi-Valu
Due to Hi-Valu’s relative strength and bargaining power, the Challenger offer seems very one-sided in Hi-Valu’s favor. It’s fair for Baldwin to negotiate a better deal with either a better price or more favorable terms as to inventory, goods on consignment, and payment of invoice. The latter seems more promising, as Hi-Valu, which is in the discount business sector, could be more sensitive to price.
Arrange external funding
Unless Baldwin can arrange sufficient funding, all the efforts for the new business will be in vain. In light of the company’s current financial situation, the best way to arrange funding is to seek short-term financing from Hi-Valu to get the business off the ground. Another solution could be to obtain a better term with Baldwin’s supplier. The company’s increased demand for material could give it more power to bargain a longer payment period or better price.
