Question

Meredith and James Kennedy own a business, Office Products, Inc. (OPI), which is a wholesale distributor of office equipment. Sales have grown about 5% per year over the past 5 years and are expected to grow at the same rate in the future. This past year, sales reached $800,000. A computer manufacturer recently approached OPI about becoming the exclusive distributor for one of its laptop computers. Sales are projected to be $400,000 from this product in the 1st year and to grow at 20% for 2 years before settling down to a 5% growth rate over the longer run. It is possible, however, that sales from this product could be as high as $800,000 in the 1^st year. OPI has been earning a before-tax profit of 6% of sales. Variable operating costs are expected to remain the same percentage of sales, even with the added laptop sales. Fixed operating costs would be unchanged. Meredith and James are aware that increased sales will mean they need to maintain additional inventory and accounts receivable. They will also need to purchase additional equipment. OPI currently has no debt, but it can acquire additional short-term financing from a bank. It could borrow up to $50,000 at 10%. Above $50,000, the interest rate would increase to 12%. It is not possible to raise more equity, so any external financing would have to come from bank financing.

Your Task: The Kennedys have asked your help in determining whether taking on the new product line would be in their best interests. Since they are content for the most part with their present business, they feel that to take on the additional product line, the financial rewards would have to be significant and the added debt load not too stressful. Write a one- or two-page memo to the Kennedys offering your recommendation supported with reasons and evidence. Attach to your memo any graphics that you think would be helpful. The Kennedys have no training in finance, so address them as a nonexpert rather than expert audience.

Answer 1