MBA Project Final

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MBA Project Final

Executive Summary

            Due to the recent stagnant status of net income for L.S. Starrett Company, it has become apparent there is a need for change.  The expansion into China will give L.S. Starrett the change it needs because it will lower the cost to produce the parts for its power tools but allow them to keep the branding revolved around America.  While there are some risks with moving a portion of any business overseas, the projections accompanying this report will show that the gain for the company is well worth the risks.  The net income will quadruple in just 7 years allowing the company more capital for reinvestment into future projects.

Investment Project Description

            Due to the consistent low net income year after year, L.S. Starrett is seeking to move most of its manufacturing of parts overseas while keeping the assembly of the machining tools in the United States.  This will allow the company to cut costs for parts but keep quality and the ability to assemble the parts into finished products in the US to be able to keep behind the branding “American Made”.  The only difference is, instead of stating made in the USA on the product, it will need to say assembled in the US.  “In contrast, products displaying an ‘Assembled in the USA’ label will contain a higher percentage of imported components but will be physically assembled in America” (Stewart, 2017). 

            Making this investment will allow the company to keep their pricing for finished products as they are but allow them to increase the profit, they make for each tool sold.  Lowering the cost of manufacturing decreases the overall expenses to make the product the consumer purchases.  This allows the company to keep the retail prices the same but allow them to make more off each piece sold.  Revenues will remain the same while expenses decrease which in turn increases the net income.  Net income can then be reinvested into the company to allow for possibly expansions or new products in the future.  Over the last several years the net income for the company has averaged about $500 if you add every year together and divide by the 5 years in question.  This is not enough net income to be able to sustain the company as well as expand or better the company.  Increasing the net income each year will make the company look like less of a risk to investors allowing the company to possibly seek more funding for projects in the future.  “Declining net profit reduces the cash available to cope with problems that can occur through the normal course of business operation, including equipment failure and damage to your business’s physical location” (Lister, 2019).

            Since China is already established as a major parts supplier for a lot of name brand tool companies, it should prove to be an easy change to get the parts for the tools manufactured there.  The best way to go about this would be research companies in China that already manufacture like parts and work with that company or companies to come up with an agreement to manufacture the parts for L.S. Starrett.  Doing this will continue the assembling jobs in the United States while allowing for the company to save money on the price of parts as materials and labor cost less in China.

            To measure the success of this plan will be to see higher profit margins.  Higher profit margins due to less expenses for production will equal a higher net income.  A higher net income will give the company more money to reinvest into the business for future projects and expansions.  As well as give them more a barrier in the event the marketplace drops out for an undetermined amount of time.  At the current net income levels, the company would only be able to survive a short time with their current income and expenses.

            The first obvious resource that will be needed is the loan to provide the funds for the expansion.  When taking on a loan it means taking on an added expense so the company will most definitely need to accommodate the increased expense of the loan by cutting other costs somewhere, like the price of the parts to build the tools. 

            Extensive research into the market and the area in which the company plans to expand is most definitely needed.  Each region of China has different economic and social growth, requiring any company looking to expand there to do extensive research as to whether their growth into China will prosper or not.  “For example, there are huge variations between different provinces in terms of population levels, per capita GDP, average income levels, consumer spending habits, education levels, literacy rates, lifestyles and so on.  As such, it is certainly no exaggeration to state that rather than representing a single, unified market, China is a collection of individual sub-markets defined by vastly differing demographic, economic and cultural characteristics” (Hedley, 2020).  According to the research by Hedley, the provinces that would most likely fit the expansion of this company are Jiangsu and Beijing.

            Expansion into Beijing may be easier as the US has an embassy in Beijing making it easier to work through and adapt to the different government and regulation policies.  Understanding the differences in government regulations and regulations is peril in a successful expansion.  Although China’s entry into the WTO (World Trade Order) in 2001 helped relieve some of the stresses of different government regulations and controls, some industries remain off-limits to foreign companies.  “For example, China severely restricts foreign companies’ involvement in the field of petrochemicals, energy and telecommunications sectors.  Any foreign company looking to set up local production in China should first consult the China foreign investment catalogue, which divides foreign investment projects into ‘encouraged’, ‘restricted’ and ‘prohibited’ categories” (Hedley, 2020).

            The company should also consider its Foreign Investment Vehicle.  How the company enters China through government and regulations has advantages and disadvantages.  For the sake of L.S. Starrett, a joint venture (JV) would be the best strategy.  Advantages to a JV include lower cost base, access to partner’s existing resources, and production facilities already established.  Some disadvantages include there being a long negotiation period, less managerial control, and challenges in agreeing to partnership terms.

            There will also be a need to hire some staff.  Staff will need to be on-the-ground in China to act as a constant liaison between the foreign company they are partnered with and their home country company.  This will need to be someone fluent in the Chinese language, culture and government policies and regulations.  This will help to relieve some of the risks associated with expanding the business to China.

            Any Trademarks or Patents that are particular to L.S. Starrett should also be registered in China in advance to expanding to that country.  “IPR infringement is commonplace in China, and any company entering the market for the first time should work under the assumption that its technology will be compromised at some point.  It is generally recommended that foreign companies, and particularly those with large IP inventories, consult with lawyers and IPR specialists to formulate an IPR strategy for the China market” (Hedley, 2020).  To cover the company and its asset IPR, it is important to take the proper steps to ensure their safety in the hands of foreign country.

            The project should start immediately, allowing due diligence in researching marketplaces, companies to possible partner with, and government regulations and policies.  Within a year the expansion process should be able to begin.  Short contracts/partnerships should be put into place to ensure the expansion is going to succeed.  In the event it fails, a short contract to begin with will allow for either partner in the partnership to bow out without legal recourse. 

Justification

            As the world continues to grow and interconnect, globalizing the company makes sense.  “Establishing a regional presence in a new market can increase efficiency. Rather than operate as a foreign entity and subject yourself to import restrictions, it often makes sense to set up a subsidiary or make an acquisition in a target market in order to create a local presence and transact as a domestic entity” (Gerlis, 2019).  The threat of increased tariffs or a possible trade war make it even more important to get a presence established among foreign borders to be able to connect to a larger customer base. 

            US markets are fixed while foreign markets are more elastic.  With the high competitiveness in the US market, the company might become a leader in a foreign market.  The current stock market expansion has made businesses more confident in perusing expansion to foreign countries.  For some businesses the corporate tax code reform has also created surpluses of capital to allow room for growth.

            Another reason for expansion into a foreign country is the stricter immigration policies.  It makes it harder for companies like L.S. Starrett to hired skills workers.  With China being the leader in the industry for skills workers when it comes to electronics, one can clearly make the connection as to why there is a need to expand.  China knows how to produce quality electronic pieces for less than what a US manufacturer can. 

            Financially, the company has no choice but to expand.  Expenses need to be decreased in order to increased profits.  While there will an added expense because of the loan for capital, the decreased amount spent on the parts to assemble the company’s products can over the amount of the loan plus leave a larger profit margin for the products without increasing the prices to the consumers.  Due to the stagnant status of the net income for the company, a change is desperately needed.  Should the economy start to crash, the company will not have the capital to ride out the storm and will be forced to close unless changes are made.

            The expansion will meet the need for the company to increase their net income to accommodate for future projects.  New technology in the line of electronics and new needs in the lines of power tools.  Technology is ever changing and as it changes the company needs to be able to change with it.  Technological changes come at a price and the company needs to be able to adapt more quicker than later.  “Manufacturers continue to make bigger and better power tools, and now they’re going high tech. Recently, they’ve come up with a number of significant innovations, especially when it comes to cordless power tools” (Carleton, 2016).  One example of an upcoming technological change in power tools is smart technology.  The industry is working on making an app that will coordinate with a person’s power tool to help them find it if it is lost.  This will require computer technology within the power tool.  To keep up with industry standards for power tools, L.S. Starrett will need to be able to quickly implement the newfound technology or sales may start to fall.

            The expansion will allow the company to build a partnership with a power tool parts supplier overseas which will decrease the amount of money spent to produce the finished product.  However, the company will have the ability to keep all assembly within the US allowing them to keep their patriotic branding.  Instead of just saying “Made in America” though, it will now say “Assembled in America”.  Consumers will still see the “America” that makes the product unique, but it will allow the company to save money without having to increase the consumers cost.

            The assumptions made for this funding project were the remaining constant of the business tax rate being 35 percent.  Also remaining consistent is that expenses will be 70 percent of total revenue.  Salaries will increase at a constant rate of $2,000,000 per year as there will be more jobs available due to the increase in facilities to be ran.  Total revenue will also increase consistently at $10 million a year due to the increase in exposure within the markets of China.

            Going with these assumptions, a 7-year projection shows the overall net income more than quadrupling.  This means that instead of $1,071,000 in net income, at the end of year 7 there will be just over $6,000,000 in net income (see Appendix A) that will be available to reinvest into the company and future projects.  However, the projections for salary, general, and administrative expenses seem higher than it would be.  While they may increase some over the first 3-4 years, they should taper off and become a consistent amount after that point with no new projects or major events added into the mix.

            Demand for power tools will remain high as there is a constant need for them in building and renovating of homes and commercial buildings and even mechanics.  So, while the demand stays consistent, being able to keep a consistent price for the products will ensure consumer loyalty to the products of the company.  “Customer loyalty is the result of consistently positive emotional experience, physical attribute-based satisfaction and perceived value of an experience, which includes the product or services” (Beyond Philosophy).  With there being a slight change in branding, from “American Made” to “Assembled in America”, it will be extremely important to keep the quality and pricing factors consistent to retain customer loyalty.

Risks

            Internally speaking there are several risks and opportunities involved in this investment project.  One risk of this investment is the loss of employees.  Due to moving parts production overseas, some departments that previously made the parts state side will no longer have work.  This however also poses an opportunity for those employees.  It allows them the chance to possibly move up in the company or get transferred to one of the other departments and learn a new aspect of the business.  There is also the possibility for some to move up on the production side of things and move overseas with the production of parts to oversee the work being done there.  Who better to teach the process of producing the parts than the employees that have done right from the start?

            Another internal risk is investors that signed on because of it being a “Made in America” brand.  It will take careful finesse when dealing with announcing the project to these investors.  The product will no longer be made in America, but it will be assembled in America.  If the company can keep the investors that are focused on the American branding committed, it will be great otherwise the company may lose some capital from investors.  If this happens the company will have to find new investors that are on board with the expansion to replace the capital funding.  Not replacing the capital funding could leave the company in the same boat it is now with barely any net income at the end of each year or they could go under. 

            Externally there isn’t a lot of risk in the expansion project if due diligence in done in researching companies to joint venture with and the area in which the company expands to.  So many companies have already made a similar expansion.  The industry the company is part of is not one of the ones prohibited to expand into so the risk should be low.  It may however, open opportunity to expand the customer base.  Being an American based company, the chances of Chinese potential consumers knowing the product is probably slim.  Have Chinese start producing the parts for the products though and they are going to become intrigued and may decide to order finished products from the company.  Hence increasing potential revenue and in return increasing net income.

            “China is exposed to an array of natural hazards, including droughts, earthquakes, floods, heat waves, landslides, severe cold, typhoons, and volcanoes. In recent decades, frequent natural disasters have caused high loss of life and damage to property in the country, endangering the country’s development gains” (GFDRR, 2019).  This is potentially the greatest external risk of the project.  Beijing being a target area for the expansion some research has been done into the types of natural disasters that occur there.  The most prominent of disasters being flooding.  When finding or building a manufacturing plant for parts, careful consideration will need to be taken of location and the risks of flooding.  Materials for building may have to be specialized to prevent flood waters from entering the plant therefore costing the company more.  In the long run however, taking the time to try to prevent the issue from occurring is a priority to prevent millions in clean up and rebuilding later.

            Economically speaking, the greatest risk to the company right now is the US-China trade war.  Although the US and China have started to work out deals the fact remains that manufacturers that currently import parts from China are paying higher costs due to the trade war.  “American manufacturers and other businesses that import parts and components from China will continue to pay higher costs to procure them” (Swanson, 2020).  With however, American manufacturing has stalled since the start of trade war.  The attack on the Iranian commander has also played an economic role on trade as well as Americans are afraid of retaliation from the Middle East.  By the time the project is ready to completely move forward to China though, the trade war should be mostly resolved reducing the cost to import the goods once again.

            Should sales fall 20% after the expansion, it will greatly hurt the overall goal of the expansion.  Net income will remain the same as it has been recently or fall some due to the added cost of the loan for the financing.  In the event this happens, the company will be forced to move production back state side and sell off any assets overseas.  An increase in sales of 20% on the other hand will allow the company more net income to be able to finance research and development of the current products they manufacture or finance for future projects.  According to calculations, a 20% increase in sales for the year 2020 would increase the net income from the original calculations by almost $800,000 and a decrease would decrease the net income by roughly $100,000 (See Appendix C).

            With the money being invested into an expansion project, the time value of money with more than likely increase being that the expansion has the possibility of increasing the sales due to more exposure to the marketplace both in the US and in China.  “The time value of money (TVM) is an important concept to investors because a dollar on hand today is worth more than a dollar promised in the future. The dollar on hand today can be used to invest and earn interest or capital gains” (Beers, 2018). So, since the money is going to invested it can become a capital gain making it worth more down the road.  In relation to the sales variation models, the time value of money will only increase if the sales increase due to the sales playing a factor in the capital gain. 

            The internal rate of return on the investment is going to vary.  It will be negative the first year simply because of the large amount money going out.  However, if sales continue to increase, and expenses are lowered the rate of return should increase every year after.  The higher the rate of return the better it is for the company.  “Generally speaking, the higher a project’s internal rate of return, the more desirable it is to undertake” (Hayes, 2019). 

            The payback values are going to depend on the amount of the capital needed to complete the expansion and the number of years the loan is for.  The company will take the amount they are receiving and divide it by the number of years to payback and the amount they get will be the increased amount in sales they would need to cover the expense of the loan capital.  If getting funding through a bank, loan rates and interest will have to be considered as part of the total amount received as well as it will be part of the expense to pay it back.

Financing

            When it comes to financing the potential expansion, it is important to assess all the options available when it comes to using internal financing options and external financing options.  There are pros and cons to both options.  Internal financing normally comes from retained earnings while external funding may be in the form of bonds, loans, commercial paper and equity financing, just to name a few. 

            Retained earnings are much like a personal savings account.  They are funds kept within the company that can be used for many things.  Some things they can be used for are everyday operations and capital investments.  In this case it would be a capital investment.  Two major pros to using retained earnings is there is no new debt brought into the company and there is no expensive interest rate to go with that debt.  It allows the company to stay in full control of how things run.  “Involving outsiders in your company, whether as partners, lenders or angel investors, gives them a degree of influence in how you run things” (Decker, 2020).

            Using retained earnings for funding expansion is slow.  There’s a risk that business opportunities will be missed due to the need to save up funds.  Retained earnings is also used for everyday operations. “If you devote too many of your resources to growth, you may be starving your company of the cash it needs to be healthy right now” (Decker, 2020).  Although the other option of external funding means the company gives up a degree of control, there may be an asset in having the extra insights and expertise of the added business players.

            “Choosing self-financing over outside investment or credit is always a judgment call, so take advantage of the best judgment at your disposal” (Decker, 2020).  With current net incomes for the past 3 years (See Appendix B), only being a little over $1 million it would take several years to save enough money to complete the expansion project.  Unfortunately, with the last 3 years net income only fluctuating between $900,000 and $2.3 million, that would mean it would take at least 3-5 years to save enough retained earnings to complete the expansion using internal funding.

            Pros to outside funding include preserving resources.  This means it allows the company to save it’s retained earnings for other business opportunities.  “If you can find an investment that has a higher interest rate than the bank loan your company just secured, it makes sense to preserve your own resources and put your money into that investment, using the external financing for business operations. You can also set aside your internal financial resources for cash payments to vendors, which can help improve your company’s credit rating” (Root III & Thompson, 2019).

            Growth is another pro of external financing.  “For example, if your business is growing to the point that you need additional manufacturing space to keep pace with demand, external financing can help you get the funding you need to build your addition. External funding can also be used for making large capital equipment purchases to facilitate growth that the company cannot afford on its own” (Root III & Thompson, 2019). 

            Another advantage to outside funding is taking on more advice and expertise.  For example, a banker would have expertise with working with other business to obtain funding and funding options.  The banker would then be able to use the knowledge he had from other experiences to help the company go in the right direction.

            A disadvantage of outside funding is that some resources require the company to give up a portion of ownership in collateral of the monies they are receiving.  “You may get that large influx of cash you need to launch your new product, but part of the financing agreement is the investor is allowed to vote on company decisions. This can compromise the vision you originally had for your company when you founded it” (Root III & Thompson, 2019).  For some companies this may be a downfall but for others it may also be an asset as it is somewhat of a checks and balances in the area of financial decision making as well.

            Another drawback to outside funding is the interest assessed on the funding during repayment.  This increases the amount the company pays back compared to what the company borrowed.  “Interest adds to the overall cost of the investment and can make your external funding more of a financial burden than you had originally planned” (Root III & Thompson, 2019).

            Finding the right kind of outside funding is also very time consuming.  For this expansion though it is the best option to be able to complete the expansion in a year or two versus 5+ years down the road.  More precisely a loan through a bank would be the best option so the money goes directly the project at hand, however if that is not an option then selling stocks or bonds may have to be what happens to get the capital needed for the project.

            “A business combination is a transaction in which the acquirer obtains control of another business (the acquiree). Business combinations are a common way for companies to grow, rather than growing through organic (internal) activities” (Bragg, 2018).  This would not be in the best interest of the company for the expansion because there is no need to acquire another business that manufactures the same thing.  The expansion for this project needs to focus on keeping the same quality parts it uses to assemble the parts for the power tools the company makes but taking measures to reduce the cost of making these parts.

Track Record

            According to Appendix B, there has been a steady but slow increase in net income from 2017-2019.  With, having the funds available to pay back the funding should not be an issue.  Once the project is completed, expenses will be lower allowing room for loan payments while increasing the net income.  The net income might lower a little or remain about the same in the time being.

            In the history of the L.S. Starrett company there has only been reportable legal incidents.  This makes L.S. Starrett extremely dependable and trustworthy.  There has never been a bankruptcy of any kind.  According to Morningstar.com (2020), L.S. Starrett is currently sitting at a current ratio of 3.73.  While good current ratios are generally between 1.5% and 3%, a current ratio of 3.73 is just over that 3% mark and indicates the company is still in good financial health.

Question and Answers

Question: How long has the company been in business?

Answer:  The company was founded in 1880 and was built on the foundation of humanity, integrity, and honesty, as per the letter from Douglas Starrett himself that is the first thing employees read in the Code of Conduct (Starrett.com, 2018).

Question: What is the current debt ratio?

Answer: According to Morningstar.com (2020), the current debt ratio is .38 or 38%.  “From a pure risk perspective, lower ratios (0.4 or lower) are considered better debt ratios” (Ross, 2019).  Since the debt ratio is already lower than 40% it would indicate that L.S. Starrett is a low risk business to give a loan to.

APPENDIX A

APPENDIX B

APPENDIX C

References

Beers, B. (2018). Why the Time Value of Money (TVM) Matters to Investors. Retrieved from https://www.investopedia.com/ask/answers/033015/why-time-value-money-tvm-important-concept-investors.asp

Beyond Philosophy. (ND). Customer Loyalty. Retrieved from https://beyondphilosophy.com/customer-experience/customer-loyalty/

Bragg, S. (2018). Business Combination. Retrieved from https://www.accountingtools.com/articles/2017/5/10/business-combination

Carleton, J. (2016). Three Power Tool Trends You Should Know About.  Retrieved from https://www.hardwareretailing.com/power-tools-trends/

Decker, F. (2020). Pros & Cons of Financing Expansion Through Retained Earnings. Retrieved from https://smallbusiness.chron.com/pros-cons-financing-expansion-through-retained-earnings-40390.html

Gerlis, J. (2019). There’s Never Been a Better Time to Expand Globally-But is Your Business Prepared? Retrieved from https://www.corporatecomplianceinsights.com/theres-never-better-time-expand-globally-business-prepared/

GFDRR. (2019). China. Retrieved from https://www.gfdrr.org/en/china

Hayes, A. (2019). Internal Rate of Return-IRR. Retrieved from https://www.investopedia.com/terms/i/irr.asp

Hedley, M. (2020). China Market Entry Strategy: A Guide to Entering Chinese Business-to-Business Markets. Retrieved from https://www.b2binternational.com/publications/china-market-entry/

Lister, J. (2020). What Impact Does a Net Profit Decline Have on a Company? Retrieved from https://smallbusiness.chron.com/impact-net-profit-decline-company-23911.html

Morningstar.com. (2020). The L S Starrett Co. Retrieved from https://www.morningstar.com/stocks/xnys/scx/financials

Root III, G.N. & Thompson, J. (2019). The Advantages & Disadvantages of External Financing. Retrieved from https://smallbusiness.chron.com/advantages-disadvantages-external-financing-10033.html

Ross, S. (2019). What Is A Good Debt Ratio?. Retrieved from https://www.investopedia.com/ask/answers/021215/what-good-debt-ratio-and-what-bad-debt-ratio.asp

Stewart, M. (2017). The Made vs. Assembled in America Issue. Retrieved from https://www.itimanufacturing.com/news/made-vs-assembled-america-issue/

Swanson, A. (2020). U.S. Manufacturing Slumps as Trade War Damage Lingers. Retrieved from https://www.nytimes.com/2020/01/03/business/manufacturing-trump-trade-war.html

MBA Project Final