Question: Diversifying to survive recessions

Omega Enterprise is a wholesaler in Yorkshire that has been trading in lorry tyres for over 35years. Its business has proven to be successful over the years with profits doubling over the last 5 years. At a recent board meeting, members of the board of directors expressed the desire to diversify its operations into unrelated industries in the wake of uncertainties in the global economy and the threat of a recession. The chairperson of the board has proposed that the company can diversify into either the food and beverage industry or the clothing and apparel sector. They requested the accountant to prepare cash flow projections for the first 10 years and the finance officer to prepare estimates of the costs involved in either project and suggest sources of finance. The cash flow projections by the accountant is in Table 1.

Table 1: Net Cashflow projections

The finance officer has estimated that the company will need an initial investment of £151,650 for the food and beverage business and £56,280 for the clothing and apparel business. She also provided information on some ratios for both industries which is shown in table 2.

Table 2: Financial ratios

Now the accountant and the finance officer have submitted the estimates and projections to the board but the members of the board are not clear how to interpret or use the information they have been given. In a meeting with the board the finance officer expressed scepticism about the timing of the new project. She thinks because of the war between Russian and Ukraine and its potential effects on the European and the UK economies, a long recession was imminent. She also pointed to recent inflation and interest rate patterns citing the Office for National Statistics and the Bank of England websites. She is suggesting that the proposed project should be postponed for at least 2 years. The board chairman however disagrees with her and has argued that the uncertainties are the reasons why the business needs to urgently diversify. 

Required:

You have been contracted by the board as an independent consultant to advise them on the above matter. The board has asked you to write a comprehensive report of about 2400 words and submit the report in the next 2 weeks.

Your report must include an interpretation and discussion of the industry ratios, an NPV calculations and one other investment appraisal technique and a recommendation on which project to pursue. It should also include a discussion of at least 2 alternative sources of finance for the recommended project. You must give reasons to justify every recommendation. The relevant discount rate for Omega Enterprise is the August 2022 Bank of England Base Rate plus 5 percentage points.

You should also respond to the concerns of the finance officer by discussing what is meant by a recession, causes of a recession and its likely effects on Omega Enterprise’s current business and the project you have recommended. Explain the implication of the trend of inflation and interest rates on the business and how the war between Russia and Ukraine could impact the business. You are free to also discuss the effects of other industry specific factors and other macroeconomic variables.

A good report is one that is research based and supported by relevant data. You can include an appendix to your report where you can show tables, graphs and other information you did not produce but which will be helpful to Omega Enterprise’s board of directors to make a decision.