Business Performance

Term 1
2024

Case Study Assessment

Dhruba Das
Overview/ Executive Summary

Regulatory requirements

Accounting policies and disclosures

Significant events and decisions

Part A

Non-financial Considerations

1. Customer Service and Brand Image

Transitioning to in-house bike servicing aligns with customer feedback demanding

more flexibility in servicing schedules, as noted by Jas Singh, R10's Marketing
Manager. Customers currently lack direct interaction with the servicing process,
described as a "big black hole" due to the outsourcing arrangement. It directly
impacts customer’s choice on looking for a second option with the facility.

Justification: By bringing this service in-house, R10 can directly respond to the
identified gap in customer service quality and the desire for greater servicing
flexibility and quality. An enhanced service experience strengthens the brand image,
potentially attracting more customers and retaining existing ones.

2. Operational Control and Quality Assurance

Currently, all bike maintenance services are outsourced to Steve's Cycles, and this
arrangement has led to a lack of control over the service quality and customer
experience. This increases the lead time in service delivery and risk of significant
quality issues.

Justification: In-house servicing will provide R10 with direct oversight of operations,
allowing for immediate adjustments based on customer needs and operational
challenges leading to more efficient service delivery and the ability to introduce new
services more rapidly. This can lead to better alignment with corporate standards
and quicker response times to customer feedback or issues.

3. Strategic Flexibility and Responsiveness to Market Trends:

The bike retail industry, particularly the segments concerning e-bikes and mountain
e-bikes, is experiencing rapid growth and evolving consumer preferences. Now given
these types of bikes are conventionally expected to be offering key features offered by
particular entities, which creates a scope of market differentiation.

Justification: Transitioning to in-house servicing would require hiring skilled

technicians or training existing staff, enhancing the company's skill base. By
integrating servicing operations within its business model, R10 gains greater agility
to quickly adapt its service offerings to meet emerging trends and customer needs,
providing a competitive edge in a fast-changing market.
4. Sustainability and Environmental Impact

The industry has had a significant growth in e-bike over the years along with their
technical servicing requirements, also partly due to sustainability factors, like
reduced traffic congestion and cleaner air. Environmental malpractices of dumping
wastes and interfering the ecosystem it might build up to act against R10, hampering
future growth.

Justification: By doing strategic investment and incorporating sustainable practices

and ethics in its operations, R10 can strengthen its commitment to environmental
responsibility. This could appeal to increasingly eco-conscious consumers, thereby
enhancing R10's brand values and contributing to a positive social impact.
Emphasising sustainability in their operations and corporate ethics could
differentiate R10 not just in service quality but as a leader in environmental
stewardship within the industry.

Financial Considerations

1. Initial Capital Expenditure and Ongoing Costs

The financing method of the initial $1.2 million cost for renovations and equipment
installation represents a substantial capital outlay. The additional revenue of
$500,000 in the first year, with a 20% increase in subsequent years. A high risk of
the projections being scrutinised, especially since the operating costs have not been
finalised and are expected to be a higher percentage of revenue than currently
experienced.

The identified ambiguity poses a risk to accurately assessing the project's

profitability. Given the proposal's considerable upfront investment, understanding
the detailed breakdown of expected operating costs is essential. Furthermore, how
the investment is financed (e.g., debt vs. equity) could affect the company's leverage
and cost of capital, impacting the NPV and the project's overall attractiveness.

2. Accuracy of Forecasted Revenues

The marketing manager's forecasts are used for workshop revenue and incremental
sales. However, Pablo Tide, the CFO, notes that the marketing manager's revenue
forecasts tend to be overly optimistic, with actual results achieving at best around
90% of forecasted numbers. This might inflate the expected benefits, skewing the
NPV calculation positively.

Given this historical trend, it is crucial to adjust the revenue projections to reflect a
more realistic scenario. Overestimating could lead to an overly favourable NPV,
potentially misleading the decision-making process. It is important to adjust to
reflect historical accuracy, mitigating the risk of overestimating the project's financial
viability.

3. Depreciation and Tax Calculations

The NPV calculation incorporates a verified flat depreciation rate and tax amounts
for the new workshop equipment is crucial for ensuring that the tax benefits
associated with capital expenditure are correctly captured. However, the financial
impact of this depreciation may vary depending on the chosen method (straight-line
vs. accelerated). The method used can affect the reported annual profits and tax
liabilities. Additionally, the salvage value of the equipment at the end of its useful life
is not considered, potentially underestimating the future value.

Given that depreciation is a non-cash expense, depreciation of the new workshop

equipment and renovations contributes to tax shields, reducing the net tax liability
and impacting cash flows positively. Ensuring these amounts are accurately
calculated and applied is critical, as it affects the overall assessment of the project's
financial return.

4. Discount Rate Appropriateness

The NPV calculation uses a 4% discount rate, which has been R10's standard for over
five years. This rate is crucial as it reflects the company's cost of capital and the risk
associated with the project. The appropriateness of this rate should be evaluated in
the context of current market conditions and the specific risks of the project. If the
rate is too low, it might not accurately reflect the project's risk, potentially making
the investment seem more attractive than it actually is.

The chosen discount rate of 4% is essential to reassess for its appropriateness

periodically, especially in light of any new financial risks associated with the project
and current market conditions. A rate that accurately reflects the cost of capital and
the specific risks of this investment is crucial for a fair valuation.

Recommendation on proposed renovations and installation of

workshop

Based on the analyses conducted in Tasks A and B, it is recommended that we

should proceed with caution with the proposed renovations and the installation of
workshops and equipment.

The global and domestic trends towards e-bikes and the increasing demand for bike
servicing align with R10's strategic move to bring bike servicing in-house which could
significantly enhance customer loyalty and potentially higher sales volumes over time
maintaining its competitive position. On the other hand, the accuracy of the financial
risks necessitate a careful and conservative approach to financial planning and
budgeting for the project.

However, the significant financial and operational risks identified require a

comprehensive and conservative approach to project planning, execution, and
financing for the strategic benefits of the project with its potential financial
implications.
Part B
Bank Overdraft:

A bank overdraft allows R10 to temporarily exceed its current account balance,
providing flexibility for short-term financial needs. However, overdrafts typically
have higher interest rates compared to long-term financing and are usually suitable
for short-term liquidity needs rather than significant capital expenditure projects.
Given R10's good relationship with its bank, this option may be viable for very short-
term needs but might not be the most cost-effective for a $1.2 million capital
expenditure that likely won't be repaid quickly.
The bank overdraft is flexible but potentially expensive and better suited for short-
term needs. An overdraft is flexible and could be increased for short-term needs.
However, given R10’s existing financial commitments and the significant amount of
$1.2 million needed, relying on an overdraft might not be prudent. It could
potentially increase the cost of finance due to higher interest rates associated with
overdrafts and impact the debt-equity ratio unfavourably.

Medium-term Bank Loan:

A medium-term bank loan provides a fixed amount of capital with a repayment
schedule over several years, usually at a lower interest rate than an overdraft. This
option would offer R10 predictable monthly payments and could be tailored to match
the project's cash flow generation. Given the amount involved and the project's
nature, a medium-term loan could provide a balance between cost and flexibility. The
good relationship with R10's bank suggests favourable terms might be negotiated.
The medium-term bank loan offers a structured repayment plan that could align with
the project's cash flows, potentially at a reasonable cost, making it suitable for this
type of investment without diluting ownership. However, it's essential to consider the
impact on the debt-equity ratio and the times interest cover. With existing medium
and long-term loans already in place, additional debt might strain the covenants,
especially if the interest rates increase, as the additional debt would increase
financial leverage and the burden of interest expenses, potentially jeopardising the
3.1 times interest cover requirement.

Issuing Shares to a Venture Capitalist:

This option involves selling a portion of R10's equity to a venture capitalist in
exchange for the needed funds. While this option doesn't impose interest payments,
it dilutes existing shareholders' ownership and might introduce new dynamics to the
company's governance, depending on the stake given away. Harry Guild, R10's Board
Chair, has good networks within the venture capital community, which could be
advantageous. However, the implications of shareholder dilution and the influence of
the new investor must be carefully considered.

Issuing shares to a venture capitalist could provide the necessary funds without
incurring debt but at the cost of equity dilution and potentially complicating the
company's governance structure. This option does not impact the debt-equity ratio
directly since it involves equity financing rather than debt. It also doesn't affect R10’s
ability to cover interest expenses, as no additional interest-bearing debt is
introduced. Issuing shares to a venture capitalist could bring in not only the required
capital but also potentially valuable expertise and networks. However, it would dilute
existing ownership and could alter the company's strategic direction, depending on
the terms negotiated with the venture capitalist.
Evaluation and Recommendation:

Considering R10's need to maintain flexibility in its financial structure while also
funding significant capital expenditure, a balance must be struck between immediate
cash flow impacts, long-term financial health, and the strategic direction of the
company.
The medium-term bank loan appears to offer a balanced approach by providing a
structured but flexible repayment plan that aligns with R10's projected cash flows
from the workshop additions and sales increases. It keeps the company's equity
intact while leveraging the existing positive relationship with the bank.

Furthermore, the medium-term loan's impact on financial ratios and covenants must
be closely monitored. Adjustments to the loan terms, such as interest rates and
repayment schedules, should be negotiated to align with R10's financial forecasts and
strategic goals, ensuring they do not compromise the company's operational
flexibility or financial health.

Part C

Analysing the Revised Funding Option / Increasing the Medium-term Loan:

Interest Rate Increase:

The increase in interest rate on medium-term loans will raise the cost of borrowing
for the portion of the capital funded through the medium-term loan. It has to be
weighed against the expected increase in EBIT (2% per annum) to determine if the
higher interest expenses can be comfortably covered by the projected earnings
growth.

Overdraft Finance Costs Ignored:

Ignoring overdraft finance costs might simplify financial analysis, but it is crucial to
consider the company's liquidity and working capital needs, especially in the context
of significant capital expenditure. R10 needs to ensure it has adequate working
capital to meet its short-term obligations without overly relying on its overdraft
facility, which can be an expensive and risky financing method.

Existing Covenants Achieved:

Assuming that R10 maintains compliance with its banking covenants suggests that
R10 is in a healthy financial position and capable of managing additional debt.
However, the increased debt level from the new funding could strain these ratios,
particularly if the anticipated benefits of the workshop renovations do not
materialise as expected.

EBIT Increase:
A projected increase in EBIT by 2% per annum is optimistic and suggests confidence
in the company's growth prospects. However, this projection needs to be realistic and
must be sufficient to cover the increased costs of financing and the capital
expenditure, ensuring the project remains financially viable.
Incorporating Sam O'Leary as a Private Investor:

Financial Impacts:

1. Equity Dilution: Bringing Sam O'Leary on board to fund 40% of the capital
expenditure in exchange for equity introduces dilution for existing shareholders.
However, it also reduces the overall debt burden by substituting part of the potential
debt with equity, potentially improving the debt-equity ratio.

2. Strategic Benefits: Beyond financial considerations, Sam O'Leary's involvement

could bring strategic advantages, including business networks, industry expertise, or
new business opportunities. These intangible benefits should be factored into the
decision-making process.

Recommendation:

Based on the assumptions, a thorough financial analysis is required to assess the

impact on cash flows, debt servicing, and financial health, including calculating the
project's Net Present Value (NPV) and Internal Rate of Return (IRR). The decision
should carefully consider the balance between the strategic benefits of in-house
servicing and renovations against the financial costs of the new funding structure.
This includes evaluating whether expected improvements in EBIT will cover the
higher interest costs and support R10's growth without harming its financial ratios.

If the benefits are shown to outweigh the risks and costs, and R10's financial health
remains strong or improves, then Option 4 could be a viable choice. However, this
decision must come after a detailed risk assessment, including sensitivity analysis.
Negotiations with Sam O’Leary should ensure his contribution aligns with R10's
long-term interests without compromising operational flexibility or existing
ownership.