Baldwin Bicycle Case

Problem identified

Baldwin Bicycle Company (Baldwin or the Company), a small "mid-market" bicycle manufacturer, had a "private label" opportunity with Hi- Valu Stores, Inc. ( Hi- Valu), which operated discount department chain stores in the Northwest. Baldwin had to make a decision whether to accept the Hi-Valu's Challenger deal or not. To make an informed decision, the company should exam a blending of financial, marketing, and strategic implications of the Challenger deal.

Financial analysis

Current financial situation

With an annual ROA of 3.15% in 1988, Baldwin's current financial situation is not favorable at all (see exhibit 3 for ratio analysis). First of all, the company had poor assets management. The high inventories and accounts receivables, which account for 62% and 31% respectively of total current assets, substantially impair the financial liquidity (see exhibit 4 -balance sheet). As the cash ratio is merely 9.83% (see exhibit 3), the company is extremely short of cash flow and at the danger of illiquidity. The low inventory turnover of 2.9 times per year signals that the company should take measure to improve its asset management (see exhibit 3).

Furthermore, the company is facing a high risk of insolvency in the future due to its highly leveraged financing. The high Debt to Equity ratio of 1.6 may be a barrier for further financing at a reasonable cost (see exhibit 3).

Besides, the company's profitability is not promising at all. The annual return on sales of 2.49% provides the company little room for growing (see exhibit 3). Return on equity, driven by the low asset turnover, low return on sales and high D/E ratio, is shabby compared to the cost of funds.

Challenger deal profit analysis (see exhibit 1)

The Challenger deal will bring an additional $577,250 contribution margin to Baldwin. Selling at $92.29/unit, the Challenger bicycle has unit contribution margin of $23.09 ($92.29 per unit price less $69.2 per unit variable cost). The relevant costs of manufacturing a Challenger bike include materials, direct labor and variable overhead, which totals $69.2 for each bicycle. The fixed overhead costs are irrelevant to the decision making, as they will occur in any case.

However, the Challenger deal will erode 3000 units' sales of bike through the regular distribution channel. As per unit contribution margin for regular sales is $43.32 ($110.05 per unit price less $66.73 per unit variable cost), the total impact of the cannibalization will be $129,960 for the 3000 bikes. Nevertheless, it's arguable that the 3000 units' of cannibalization will eventually occur no matter Baldwin takes Challenger deal or not, if Hi-Valu enters the private label bicycle business anyway. In that case, the lost contribution margin, although it may very well occur, will not be a relevant cost of accepting the Challenger offer.

Besides, an incremental asset related cost of $143,322 will incur for carrying the added working capital involved in the Challenger deal. To meet the increased annual production, Baldwin should invest at least 685,511 in working capital including such as inventories and accounts receivable. Excluding the reduced assets due to cannibalization, the company's accounts receivable will increase 11% and inventories will increase 19%, which add $143,322.42 asset carrying cost annually. In addition, there will be a one time cost of $5000 for preparing drawings and arranging sources. Fortunately, adding the Challenger line will not incur any capital investment for additional capacity since the company's current capacity is still sufficient for the 122,000 units' annual production.

Putting all the relevant cost and benefit related to the Challenger deal together, the company could expect $298,968 incremental pre-tax profit and $161,177.03 after tax profit from the Challenger deal. For purely profit maximization purpose, the deal is attractive. The return on investment of the Challenger deal is 23.5% (=161,177.03/685,511.03), twice as much as the cost of financing receivables and inventories (11.5%).

Challenger deal cash flow analysis

As analyzed above, to earn the additional $161,177.03 profit from the Challenger contract, the company should invest at least $685,511.03 in working capital to execute the Hi-Valu contract. If the company can't get any current debt or trade payable financing, the operational cash flow will slip more than 500,000. The company's current cash of 342,000 is not enough to cover this and external debt or equity financing is needed to support the new business.

Impact of Challenger deal on ROA and ROE

The impact of Challenger deal on Return on Equity and Return on Asset is impressive, which will increase from 8.11% to 12.30% and from 3.15% to 4.73% respectively (see exhibit 3). The more than 50% improvement for both