Saturn Petcare Australia and New Zealand is Australia’s largest manufacturer of pet care products. Saturn have been part of the Australian and New Zealand pet care landscape since opening their first manufacturing facility in Albury Wodonga in 1966. Since then they have expanded their manufacturing footprint to include other sites in regional Australia and New Zealand including a world-leading manufacturing site opened in Bathurst, NSW in 2015.

Saturn Petcare Australia New Zealand manufactures for the Australian and New Zealand domestic markets as well as exporting products to more than 26 countries. Saturn Petcare is part of the larger overall Saturn Group which is globally one of the largest privately held manufacturing companies and operates in a range of different fast moving consumer goods (FMCG) sectors including manufacturing well-known chocolate, confectionary, and food brands as well as pet food and pet care products.

The Saturn Petcare product range has been under significant pressure over the last five years of trading. Almost 80% of Saturn Petcare sales in the Australian pet food market come from sales to the Woolworth and Coles supermarket groups. Because of structural changes in the grocery industry (including the impact of the entry into Australia of global chains such as Aldi) and the increasing development of internal house brands Saturn has driven growth in sales through price discounting. Sales of the once premium dog food brand ‘Friend’ at full price (without discounting) are now only 30% of total sales, with almost 70% of sales being made with Saturn offering some form of discount to the retailer. Also, both Woolworths and Coles are actively developing and promoting more sophisticated house brands which are given prime shelf position, have similar packaging, and compete directly with Saturn’s products. A by-product of constantly being on sale is that householder consumers come to expect discounts and this ultimately damages brand equity. Saturn Petcare is facing a difficult trading time.

Problem:

Nathan Quinlivan, the Demand and Strategy Finance director for Saturn Petcare Australia New Zealand, believes that Saturn needs to move away from the discounting model of driving growth and should develop new products in order to retain strong margin after conversion metrics. The company has conducted several rounds of independent research costing $500,000 and believes that a new ‘Buddy’ wet dog food product can be expected to achieve sales of AUD $20 million in the first year at $1.25 per can (unit sales of 16 million cans). Whilst unit sales are expected to remain at the same level, sales price over the life of the product is expected to increase at the long-term rate of inflation (estimated at 2.35%). Margin after conversion (gross profit) on the product is targeted at 30%. Raw materials and packaging costs vary directly with production and make up 50% of total manufacturing costs. The remaining manufacturing costs in the proposed hi-tech factory (including labour and utilities expenditure) will be 80% fixed costs and 20% variable costs. The budget for the first year of production estimates a gross profit (margin after conversion) of $6 million from the budgeted $20 million in sales. Manufacturing costs of $14 million can be broken up as $7 million raw materials and $7 million in conversion costs. Fixed conversion costs are estimated to be $5.6 million and variable conversion costs are $1.4 million ($0.0875 per unit in the first year).

You have been asked to conduct a capital budgeting analysis of the viability of the proposed new ‘Buddy’ pet food range. Saturn have a global target return on investment of 20% pa.

If Saturn proceed with this product launch a new manufacturing facility and production line with an annual production capacity of 28 million cans will be constructed at an estimated cost of $20 million. The new ‘Buddy’ product is being evaluated on the basis that it will have a 10 year product lifecycle. The new production facility will be depreciated on a straight line basis over the 10 year lifecycle to zero. Because of anticipated technology changes the production facility is expected to have a salvage value of $5 million at the end of 10 years. Saturn are an international company and pay Australian tax at the rate of 30% on profits. The capital budgeting analysis should be conducted on an after tax basis.

Prepare an excel spreadsheet calculating whether this product will satisfy the investment parameters set by Saturn Group global.

• Required:

For the proposed ‘Buddy’ capital investment calculate the following:

• After-tax cash flows.
• Payback period.
• Net present value.
• Profitability index.

Nathan Quinlivan advises you that he is concerned about the increasingly challenging business environment facing Saturn Petcare and would like to conduct some ‘what if’ analysis of the proposed ‘Buddy’ product line capital investment. Nathan is particularly concerned that traditional financial analysis does not take into account the operating leverage impact caused by the high fixed cost component in modern automated manufacturing facilities. He asks you to develop spreadsheet analysis which shows the impact of achieving 10% lower and 10% higher than the budgeted sales projections of 16,000,000 units. Nathan asks that this analysis include the leveraging impact of utilising fixed costs by showing manufacturing costs broken down between fixed and variable components.

• Required:
• For the proposed ‘Buddy’ capital investment with sales at 5% higher than estimated calculate the following:
  • After-tax cash flows.
  • Net present value.
• For the proposed ‘Buddy’ capital investment with sales at 5% lower than estimated calculate the following:
  • After-tax cash flows.
  • Net present value.

#IMPORTANT: In your analysis remember that Fixed Costs do not vary with increases/decreases in production/sales. Include Fixed and Variable Costs separately to show how operating leverage will impact on costs per unit and enable you to identify any multiplier effect on expected cash flows.

• Discuss your findings in the three cash flow analyses developed (above) and make a recommendation to Mr Quinlivan as to whether to proceed with the ‘Buddy’ proposal. Discuss any other issues or items that you think will (or should) impact on his decision including the impact of spare production capacity at the proposed new factory.

(iii)    Required:

Saturn Petcare are planning an upgrade to their Bathurst manufacturing facility which will improve product processing times and deliver savings. Management have been presented with two replacement options. You have been asked to advise, from a financial management point of view, which would be the best Option for the firm to install. Because this is an upgrade for an existing production line expenditure of this type is assessed using a risk adjusted rate of only 6%. Both options have the same cost and will deliver cash flows as detailed in the table below:

• Provide a fully worked analysis of which upgrade option should be undertaken.
• Explain the criteria on which you have based your decision.

Solution is available in MS Excel file.

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