Step 7: contribution margins



assignment twostep 7: contribution marginsI was quite concerned about completing Step 7 because PVCS has restructured, ceasing all manufacturing services. I reached out to my peers on Facebook for advice:Danielle Davenport suggested that I use past and potential projects. I thought this was sound advice so have based my costings on the manufacture of 2 different photovoltaic wafers (which were produced by PVCS) and the provision of cutting services to other companies (which they plan to offer in the future). I have had to make many assumptions on prices and costs but have tried to base these as accurately as possible based on market research. I based the price of wafers on the weekly wafer spot prices () and figure 1.1 (below) which I found in PVCS’ 2016 Annual Report. I selected two wafer types with vastly different selling prices in order to better illustrate contribution margin differences. Figure 1.1Prices were originally in USD so I converted them to Euros (as this is the currency that PVCS uses in their financial statements). I know that PVCS produced enormous quantities of wafers while it was manufacturing (203MW in 2015 and 114MW in 2016). Each wafer is around 4.5W so: in 2015, 203,000,000 / 4.5 = 45,111,111 wafers were manufacturedin 2016 114,000,000 / 4.5 = 25,333,333 wafers were manufacturedI could not find the specific variable cost so have made the assumption that it would be quite high. Products produced at such large quantities usually have smaller profit margins. I have estimated a variable price of 90% of the selling price. After looking at the high price of polysilicon in Figure 1.1 I am happy with this decision. Product 1: Mono Wafer 158mmProductSelling priceEstimated variable costContribution marginMono Wafer 158mm€0.39€0.35€0.04Product 2: High Efficiency WaferProductSelling priceEstimated variable costContribution marginHigh Efficiency Wafer€0.79€0.71€0.08The third product is actually a service. PVCS plans to offer cutting services to other industries so I have based my assumptions on the cutting of optical lenses. The selling price will be the cost of wafering each lens. I found it interesting to consider how the variable cost would change from the silicone wafering services. PVCS would still have the same fixed costs of machinery, insurances, property leases etc but would not be responsible for any of the variable costs of sourcing raw materials, glass manufacturing, packaging and marketing. The variable costs involved would include direct labour costs, additional utility costs to cover the increase in manufacture and the specific manufacturing costs (specialised components etc) Based on this assumption I have reduced the variable costs to 30% of the selling price. Product 3: Wafering of optical lensesProductSelling priceEstimated variable costContribution marginOptical lens wafering€0.17€0.05€0.12The contribution margin is the amount remaining when the variable cost of producing a single unit is deducted from the selling price. This contribution margin needs to cover fixed costs and generate profit. Understanding the contribution margin of each product is important in making product mix decisions and in calculating the break-even point. Knowledge of the break-even point allows Directors to know how many units need to be produced before a profit will be made. The manufacture of silicon wafers has higher variable costs and lower contribution margins than optical lens wafering. This is because PVCS needs to source all of the raw materials and process them before wafering. They also need to pay for the transportation of their product to PV manufacturers. The high efficiency wafer has a much higher contribution margin than the mono wafer, but this is largely due to the fact that the selling price of the high efficiency wafer is much higher. Optical lens wafering provides an even higher contribution margin as the variable cost is much lower. This is in spite of a much lower selling price per unit.When deciding which products / services to provide PVCS needs to consider the contribution margin but also the number of units that will be manufactured. Based on the contribution margin alone it would be tempting to solely provide optical lens cutting services but perhaps the market for this service is quite small. It is the market demand that determines the products and services that PVCS will provide. They can only wafer as many optical lenses as they are commissioned to do. They can only sell as many high efficiency wafers as demanded from the market. PVCS would be wise to consider market demand in conjunction with contribution margins when making product mix decisions. By doing this they will have higher asset turnover, lower inventory costs and will ensure that efficiency and profitability is maintained.There are many constraints that PVCS faces when providing these products and services. The solar market has been impacted by fierce Chinese competition and there are multiple wafer manufacturers who have flooded the market with low price products. This oversupply has seen devastating reductions in both wafer prices and demand for wafers. The uncertainty surrounding the sale of wafers could mean that PVCS has to hold a large inventory of stock while waiting for demand to increase or could be forced to sell the wafers at a lower price, thus reducing the contribution margin. Resource constraints exist with the fluctuating price of polysilicon, a key material for wafer manufacturing. As evident in Figure 1.1 the price of this resource is quite volatile and will affect the variable price of wafer production. The demand for polysilicon from the bloated solar market has increased so there is less available to each firm in the market. This could mean that PVCS is unable to physically source sufficient quantities for production. Optical cutting services are profitable but are constrained by the ability of PVCS to source a solid customer base who needs these services. The size of this customer base and the number of units that they can provide will be constrained by market forces in their own industry. If the demand for optical lenses decreases, then so will the demand for optical lens wafering. If the market price for optical lenses decreases then there will be pressure for the cost of manufacturing to be revised down, including wafering. I am aware that competition for wafering services in Germany (where PVCS’ manufacturing is based) is currently quite low. If more players were to enter the market, then this would also impose constraints on PVCS and they might find they have to lower their prices to keep their customers.The last constraint would be the wider economic climate that PVCS operates in. Wage growth, exchange rates, technological change, trade agreements, fiscal policy and civil unrest are some among many factors that could impact upon PVCS capacity to produce products and services. step 8: ratiosI approached the ratios a little too confidently and made some rookie errors. I originally entered my share price in pounds rather than Euros. I am so glad I found this error before submitting! I reached out to my peers on Facebook and through my blog to see if anyone else had encountered this. I decided to use a historical currency converter (at ) to work out the share price in Euros as at 31 December each year and Maria also recommended that I do this. I included this in my workings area. I am very relieved that the original linking meant that all of my figures adjusted automatically. Once again, I found playing and pausing Maria’s video was the key to correctly calculating my ratios. The figures in my spreadsheet are vastly different to Wesfarmers so I was originally concerned that I had incorrectly linked them. I checked again and they seem right. The many negative figures and much smaller market ratios still make me uneasy, but I think that they are a true representation of the business reality of PVCS and the low market price of shares. Fingers crossed!Profitability RatiosThe Net Profit Margin shoes how much of each dollar earnt in revenue translates into profit. For PVCS the net profit margin fluctuates wildly over the past 4 years. In 2015 and 2016 there was a negative net profit (-17% and -6% respectively). PVCS ran at a loss for these years as the cost of production for polysilicon wafers exceeded the spot market price. In addition, PVCS had a large outstanding contract with one of the world’s largest PV manufacturing companies during these years. This company had failed to purchase wafers in line with its contractual obligations, thus impacting the profitability of PVCS.In 2017 PVCS was awarded a significant arbitration payout €20.5m in relation to the outstanding contract. The UK operations were also closed in 2017 so costs for the company were reduced. These factors contributed to a substantial NPM of 38%, meaning that for every Euro in sales a 38c profit was made. I only wish that this was a true representation of the health of PVCS!2018 saw a net profit margin of 11%. This net profit was a result of a final arbitration payment of €8.2m, and reduced costs from the further downsizing of operations (lease terminations and extensive job losses) rather than from increased profitability from sales. The Return on Assets ratio demonstrates how much profit is generated from each dollar of assets. This ratio can demonstrate how efficiently a firm uses its assets to generate earnings. Again, this was a negative figure in 2015 and 2016, quite high in 2017 (17.8%) and positive but low (1.3%) in 2018. To understand these figures, I looked at the weight of each type of asset in each year. The trajectory of continual operational downsizing is evident in the decreasing property, plant and equipment assets for each subsequent year. In 2015 PVCS held €2,049,000 in property, plant & equipment but this decreased over the years to only €51,000 in 2018. In line with this, trade accounts receivable trended downwards from €5,658,000 in 2015 to a meagre €40,000 in 2018. Cash and cash equivalents equate for 48% of the assets held in 2017 and 98.6% in 2018. With little operational capacity the continued feasibility of PVCS remains tenuous. Efficiency (or Asset Management) RatiosThe Days of Inventory ratio reflects how many days it takes for inventory to be sold. For PVCS this number has consistently decreased each year (from 121.68 days in 2015 to only 6.18 days in 2018). This is a reflection of the liquidation of much stock after the closure of manufacturing operations in Germany and the UK. I also assume that the unfulfilled contract resulted in high inventory holding costs over 2015 and 2016. To compare days of inventory I decided to look at another industry player. The first few websites I landed on were in Mandarin so I hunted down a German PV wafer manufacturer, Siltronic AG. Looking at the Annual Reports I was surprised to see how healthy the firm looked. I had to remind myself why I was there and focused instead on the days of inventory. To calculate this, I used the formula:Days of Inventory = Inventory / (Inventory cost / 365)= €1,486,000 / (€421,300,000/365)= 1.29 daysThat is incredibly efficient! This means that stock is sold almost immediately after manufacture. No wonder Siltronic AG is so successful. The Total Asset Turnover ratio compares a company’s sales to its asset base. Looking at PVCS I can see that this ratio is quite small. In 2018 each dollar of asset produced only 12c of sales. This is much lower than the 47c produced in 2017 and the $1.24 earnt for every asset dollar in 2015 and 2016. I decided to compare PVCS TATO to that of Siltronic AG.I learnt that the total asset turnover for Siltronic was relatively stable sitting from 2015-2017 but dropped to the same rate as PVCS in 2018. PVCS had a substantially higher total asset turnover than Siltronic in 2015 and 2016. Perhaps I had been quick to judge PVCS as poorly performing in this area. Liquidity RatiosThe Current Ratio compares a company’s current assets to its current liabilities. This demonstrates whether a firm will have enough working capital to pay for its debts. Fortunately for PVCS it has very high current ratios across all years. In 2015 the ratio was 6.31 and this increased to 12.40 in 2016, dropped slightly to 12.32 in 2017 and shot up to an impressive 22.98 in 2018. This means that for every dollar of liability in 2018 there were 22.98 dollars in assets. I discussed this with Megan Main when I saw that her firm had a negative current ratio across all years. This means that her firm, Power Assets, may not be able to cover its short-term debts. I can see that liquidity is one of the few areas that aren’t of concern for PVCS.Financial Structure RatiosPVCS has very little debt so its debt equity ratio is very low. The debt equity ratio shows how much investment is being provided by outsiders such as banks and how much is being provided by equity investors. In the case of PVCS for each dollar provided by equity investor in 2018 only 5c was provided by a bank. In 2017 & 2016 this figure was 9c and in 2015 was 16c. I am happy to see that the level of debt is decreasing with each year. The equity ratio demonstrates the level to which equity investors are funding assets. I was happy to see that this ratio was again very high and trending upwards over all years. By 2018 95.65% of equity was funded by equity investors. I have looked at many of my peer’s ratios and have yet to find another firm with such a high figure. Before I get too chuffed and start high fiving the Director, I have to admit that this is not only due to low debt levels but also a result of small physical assets and large cash holdings. Cash assets definitely don’t need bank finance. Oh well…While I was calculating these ratios, I also quickly worked out the debt ratio. It confirmed that the amount of debt decreased each year and that debt ratio + equity ratio = 100%. Market RatiosThe very low market price of shares for PVCS had me stumped and I was initially concerned that I had incorrect figures. I looked at many of my peer’s share prices: Power Assets $54.85; Stella International Holdings $9.55 and this did nothing to quell my unease. PVCS’ share price was only 9 pence per share in 2015 and reached only 25.05 pence per share in 2018. I checked the figures that I found in the annual reports against the London Stock Exchange to ensure they were correct. The Earnings Per Share (EPS) ratio shows me the value of each share if the profit was divided amongst shareholders. This amount was actually a negative figure in 2015 and 2016 which shows that PVCS was operating at a loss with no profit available. Things improved in 2017 with €0.062 earnings per share but then decreased again in 2018 to only €o.004 earnings per share. The EPS ratio for each year follows the same trend as the net profit margin which makes sense as EPS reflects the firm’s ability to generate profit for its shareholders. Dividends Per Share (DPS) shows how much PVCS actually paid out per share in each year. My calculation showed a result of zer0 for all years until I moved along several decimal places. From the Annual Reports I am aware that no dividends have been paid to any investors over the past 4 years. The Price Earnings Ratio is a valuation ratio which can help investors understand how well stocks are priced for a company and how solid the company’s income statement is. A very high PE ratio can mean that high expectations for a stock may exist but also that the stock may be quite expensive (considering that returns will take longer). A low PE ratio means that investors are pricing the stocks at a lower amount, earning faster returns on investment, but are the market may be less confident in their expectations. A negative PE ratio shows that a company is operating at a loss. PVCS had a negative PE ratio for 2015 (-0.97) and 2016 (-10.28) as they experienced a loss in both of these years. Their net profit margin increased to 38% in 2017 and this saw the PE ratio rise to 2.95, meaning that investors could expect a return on their investment in just under 3 years. A decrease in the net profit margin in 2018 increased the PE ratio to 51.49, with an expected payback period of 51.49 years. I was interested to see that the share price in 2017 fell in spite of high profitability. I am assuming this was related to market uncertainty after the closure of some manufacturing operations. The volatility of the PE ratio should definitely give investors pause as rate of returns are very difficult to predict. Ratios based on Reformulated Financial StatementsMoving on to the ratios based on my restated financial statements I was interested to see how much separating operational and financial items would change the outlook for PVCS.The Return on Equity demonstrates how well a company generates profitability from the equity provided by shareholders. In 2015 and 2016 PVCS shareholders lost money on their investment and ROE was negative. In 2015 they lost around 24c for every dollar and in 2016 they lost 7.5c in every dollar. This is definitely not something they would be very happy about. Things improved in 2017 with a 19.33% return on equity but dropped again to only 1.34% in 2018. The Return on Net Operating Assets (RNOA) can be used like the Return of Assets (ROA) ratio but focuses on the profits solely generated by the operating activities of a firm. Knowing that PVCS had been experiencing operational shutdown I was incredibly interested to see the comparison of RNOA to ROA. You can see in the figure below that there are vast disparities between ROA and RNOA for PVCS each year. Whilst following the same general trend of increasing up to 2017 then decreasing in 2018 the RNOA is significantly different to the ROA each year. The ROA and RNOA were both negative in 2015 and 2016 but the RNOA was lower as many of the operational assets in the ROA were cash holdings that were later attributed to financial assets in the reformulated statements. The spike in RNOA in 2017 at first surprised me as I was aware of operational downsizing through this year with the closure of the UK operations. I then realised that the relatively high RNOA of 39.66% was a reflection of the reduced asset holdings and a high net cash position from the arbitration settlement.The exclusion of financial assets in calculations has resulted in a negative RNOA of -41.47% compared to the ROA of 1.3% in 2018. The closure of operational facilities and exit from PV wafer manufacturing has meant the operating assets for this year were extremely low. As PVCS has had large cash holdings and low debt levels the RNOA provides a much more accurate representation of the company’s performance than the ROA ratio. It provides a very bleak outlook for PVCS. The Net Borrowing Cost shows the cost of borrowings to the company. I was interested to see this as I am aware that compared to any of my peer’s companies, PVCS has relatively low debt levels. In 2015 the NBC was at its highest point of 4.27% before trending downwards to 0.10% in 2018. I was interested to see that although the debt/equity ratio remained the same in 2016 and 2017 (0.09) the NBC decreased from 0.17% in 2016 to 0.12% in 2017. As equity increased over this period, liabilities increased at the same rate maintaining the debt/equity ratio at 0.09. I can only assume that higher interest loans were paid off in favour of lower interest rates thus resulting in a lower NBC. I could not find the loan rates that PVCS is actually paying in their financial statements or annual reports. I was happy to see that PVCS has such low debt levels and sufficient cash at the end of 2018 to give them some breathing room for their restructure. The Profit Margin (PM) is one of the drivers of economic profit. Comparing it to the net profit margin I can see that less of a loss was incurred in 2015 and 2016 but also profits were slightly reduced in 2017 and 2018 when compared to the NPM. The trend remained the same with a large loss in 2015 (-16.10%) a smaller loss in 2016 (-5.63%), a large profit of 37.84% in 2017 reducing to a profit of 10.28% in 2018. Removing financial items from this calculation has resulted in less than a cent disparity in each year. Asset Turnover (ATO) demonstrates how efficiently a company is using its operating assets to generate revenue. In the case of PVCS the ATO is markedly different from the total asset turnover in every year. 2018 was the only year in which ATO was less than TATO (and substantially so). This is because there were more operating liabilities than operating assets in 2018. The largest asset turnover was in 2016 with an impressive 42c of sales generated from every operating asset dollar. I was interested to see that ATO did not trend in line with profitability or total asset turnover. ATO efficiency was highest in 2016 but PVCS still made a loss in this year. Profitability was highest in 2017 even though asset turnover was lower. Economic ProfitEconomic profit not only takes into account the profit of a firm against the cost of capital but also the opportunity costs of their operations. The calculation examines the relationship between the Return on Net Operating Assets (RNOA) the cost of capital and Net Operating Assets (NOA). To calculate I used a figure of 10% for the weighted average cost of capital (WACC) as I could not find the actual cost of capital anywhere in PVCS Annual Reports. As such my calculation of economic profit might not be completely accurate. I was not surprised that PVCS economic profit was negative in 2015 and 2016 as I know that they made a loss in both years. I can see that the RNOA of -31.7% (2015) and -23.7% (2016) is substantially less than the 10% WACC. In economic profit terms PVCS lost €13,648,460 in 2015 and €4,538,530 in 2016. Ouch!Things improved in 2017 with an RNOA of 39.66% and a healthy economic profit of €7,461,340. I had expected that economic profit would follow the trend of RNOA but was confused to find that in 2018 an economic profit of €804,450 was achieved in spite of a negative RNOA of -41.47%. The culprit it seems in a negative NOA figure for this year. This shows me how important all of the drivers are in achieving an economic profit. Economic profits trended consistently with Return on Equity which I had expected. In spite of recent economic profit, the outlook for PVCS remains rather glum. With little operational capacity their ability to make future profits is limited. They have the benefit of a large cash reserve and low debt levels so this will buy them some time to source a new customer base for their laser cutting services. I hope this restructure is successful for them.step 9: capital investment decisionPVCS is committed to their strategic vision of offering silicon and non-silicon cutting services to a range of industries. Currently PVCS is in cash conservation mode and is focussed purely on research and development rather than active manufacturing. However, for the purpose of this assessment I have invented some capital investment decision scenarios. PVCS has recognised that they do not currently have the capability to provide non-silicon cutting services in their current factory. They need more space and specialised cutting equipment. To achieve this goal, they have two options:The expansion of their current facility in Germany and the purchase of specialised non-silicon cutting equipment.The purchase of an existing 2-year-old non-silicon wafer cutting plant in China, closer to their customer base. This plant would operate in conjunction with their current silicon wafering plant in Germany. The rate of technological advancement in this field may mean that the existing & purchased equipment will be superseded in the next 10 years. The Chinese plant has existing 2-year-old equipment so this project will be considered over 7 years whilst the expansion if the German facility will be considered over a project life of 9 years. The Chinese plant is purpose built and will have a larger manufacturing capability than the German expansion will allow. At the conclusion of the project life the Chinese plant & equipment would be sold but the extension of the German factory would be kept for inventory storage with all equipment sold. It is assumed that it will take some time to secure a solid customer base for non-silicon cutting services for either option. The investment would commence on 1st January 2020. The estimated future cash flows are expected to be received by 31 December of each year.The initial investment cost, estimated residual value, expected useful life of the investment, and expected future cashflows for both options are shown in the table below. I applied a 10% discounted rate / WACC. All monetary values are in Euros.german factory expansionchinese factory purchaseINITIAL INVESTMENT COST-€70 million-€130 millionResidual Value€1 million€10 millionestimated useful life9 years7 yearsestimated Future Cash flowsYear 1 (2020)-€5 million-€25 millionYear 2 (2021)-€1 million-€12 millionYear 3 (2022)€8 million€9 millionYear 4 (2023)€12 million€46 millionYear 5 (2024)€16 million€57 millionYear 6 (2025)€22 million€69 millionYear 7 (2026)€31 million€69 millionYear 8 (2027)€37 millionYear 9 (2028)€39 millionInvestment decisionThe net present value (NPV), internal rate of return (IRR) and payback period for each capital investment has been calculated and can be found below. german factory expansionchinese factory purchasenet present value (NPV)€11.32 million-€9.58 millioninternal rate of return (IRR)12.38%8.73%payback period2.75 years3.07 yearsThe Net Present Value of the German factory expansion is €11.32 million whereas NPV for the Chinese Factory Purchase is a negative figure of -€9.58 million. Net Present Value calculates the value of future cash flows during a project’s life, translates these cash flows into the current value of money and compares this to the cost of the initial investment. The NPV analysis of PVCS investment options shows that the Chinese factory purchase would drain money from PVCS and hurt its shareholders and existing operations. The German factory expansion will provide value for shareholders and should be considered as it presents as a solid capital investment.The Internal rate of Return measures the profitability of capital investments. The percentage of IRR shows the rate of return that an investment is projected to make. As our required rate of return is the rate of our WACC (10%) we expect the IRR to be greater than this in order to return a profit to the company. We can see that the IRR of the German factory expansion is greater than the WACC so would create value for PVCS. In contrast, the Chinese factory purchase has an IRR of 8.73% which is less than the required rate of return. As such this option would result in a return that is less than the cost of capital. The Payback Period shows how many years it will take for the cost of a capital investment to be earned back in cash flows. In this exercise we had clear project life spans of 7 years for the Chinese factory and 9 years for the German expansion. Both projects had payback periods that fell well within these time frames. The German expansion was the shorter of the two at 2.75 years, but the Chinese factory purchase was only a few months behind at 3.07 years. I can see that considering the payback period alone may yield unreliable results. Not only does the payback period calculation not take into account the time value of money, it also fails to recognise cash flows after the payback period. As seen with the Chinese factory purchase, an investment may have a short payback period but remain unprofitable. When looking at this investment analysis it is immediately apparent that the Chinese Factory purchase should be abandoned and the German factory expansion should be given serious consideration. I think that NPV and IRR are more reliable methods to use when making capital investment decisions but can be skewed if the WACC used is incorrect. We calculated our capital investment decisions using a WACC of 10%, but if the WACC was higher or lower it would change the results of our calculations and this may mean increased or decreased feasibility. ................
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