Homers Dilemma

HOMER’S DILEMMA

SIMPSONS LTD. is a private company owned by Mr. Homer Simpson which specialized in producing machined Persian Carpets. The carpets had good demand in the market but over the years the number of competitors had increased, increasing the efforts required to market the carpets. Homer had only one dream and he knew the time to live it was arriving soon. The demand for Persian carpets was expected to peak out within next three years. Homer had decided to leave Simpsons Ltd. at the end of three years and go off to the Hawaiian Islands to spend his remaining life schooning, boozing and sleeping. He had decide to sell Simpsons Ltd. and use the proceeds to sustain his Hawaiian life style. Homer wanted highest price for his business if he sold it at the end of three years. In order to achieve this target he had approached his banker who advised him the following for the next three years:

1. To increase sales at a growth rate of 25% per anum for the next three years.
2. The current plant capacity will reach 100% once the sales are increased by 25% in the next year.
3. To support further sales he has two options:

1. He intends to support further production required in the later two years through outsourcing. The additional carpets will be procured at 80% of the expected sale price.
2. He intends to support further production by setting up additional plant and machinery of Rs.1000000/- in two equal stages in the year 2013 and 2014. This additional capacity will be enough to continue production for next 5 years wherein the total capacity will again reach its peak.

1. Marketing expenses will increase from 5% to 8% of sales.

Homer was also advised to achieve the following:

1. To reduce average collection period from 36 days to 24 days.
2. To reduce days of inventory holding from 36 days to 30 days.
3. To reduce cash levels from 5% of sales to 2%.
4. To increase average payment period from 36 days to 48 days.

To achieve the above levels of sales Homer intends to maintain the prices for next three years. As Simpsons is achieving economies of scale the raw material costs will increase at same rate per anum even though prices are maintained constant.

Other Important Information:

1. Depreciation is WDV method at 10%.
2. Bank borrowings are short-term borrowings and are related to sales.
3. In case of sale the land will be sold at at-least 3 times its book-value.
4. The expected growth rate once the demand has peaked up is a stable growth of 5%.
5. The expected cost of financing for the investor will be 10%.
6. Secured loan is repaid by Rs.100000 every year till feasible (i.e. retained earnings are able to replenish it).
7. Investments generate a return of 10% which is reinvested in the same securities unless needed otherwise. Net capex and additional working capital are financed through investments. At the same time additional revenue/ retained earnings are invested in the investments.

Which option should Homer agree for?