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Case Study: Pontrelli Recycling, Inc.

Let’s return to Pontrelli Recycling, Inc., the company that we first saw as an illustration in Chapter 2. Pontrelli Recycling, Inc.’s mission is twofold:

1. Increase the efficiency of recycling usable materials in order to create a better environment for all

2. Create value and a fair return on investment for shareholders

Let us see how the company’s mission statement and financial goals become the basis for financial managers to decide how they will operate the company in the coming year and how that will affect the choice and execution of projects. Please note that some of the information contained in the Pontrelli exhibits in this chapter has been slightly altered to accommodate the case study.

Increasing the efficiency of recycling usable materials implies benefits not only for the environment, but also for Pontrelli Recycling, Inc. Let’s say that market research has shown that both municipalities and companies would be interested in using the recycling services of a company that was able to provide two benefits:

1. It could cut the cost of recycling for clients.

2. It could increase the range of recycled materials that could be handled.

For Pontrelli Recycling, Inc., this market research represents several opportunities. If the company could decrease the cost of recycling, perhaps it could pass on a part of the savings to clients and also increase its own profitability. Decreasing the cost to clients would make Pontrelli Recycling, Inc. more competitive in the market and could be used to increase its client base and revenues.

In addition, if Pontrelli Recycling, Inc. were able to increase the range of materials that it was able to recycle, it would be able to increase the revenue realized from each client by providing more recycling services. Pontrelli Recycling, Inc. would then be in the enviable position of not only increasing revenues through new clients but also increasing revenue from each client.

Now we must also consider the other side of Pontrelli Recycling, Inc.’s mission statement, to increase value and provide a fair return on shareholder investment. If shareholders were used to seeing a 43% increase in their stock value each year, as well as an annual dividend of $1,000, then the company’s managers would need to determine whether those financial goals could be met by finding a way of increasing efficiency and recycling more kinds of materials.

In addition, Pontrelli Recycling, Inc. must consider the competition in the marketplace. Not only must the company’s leaders decide if it can financially create a benefit by increasing the company’s capabilities, it must also see what the risk is if they do not. Just as Pontrelli Recycling, Inc. could potentially increase its base of clients by implementing increased capabilities, it could also lose market share if it does not and the competition does.

On the financial side, we recall that Pontrelli Recycling, Inc. had a return on equity of 43 (43.2%), meaning that every dollar of equity (what shareholders own) that was employed produced 43.2 cents of net income. The company also had a return on capital of 29.5%; in other words, for every dollar of capital (the goods used to operate the company), 29.5 cents of net income was produced. In addition, the company had a net profit margin of 4.5%, indicating that for every dollar of revenue, Pontrelli produced 4.5 cents of net profit. Other information on Pontrelli Recycling, Inc. can be found in Exhibit 2.5 of Chapter 2.

Pontrelli Recycling, Inc.’s financial objectives included increasing the value of the company as well as creating a fair return for shareholders. The company has fulfilled this objective by increasing stock value and paying a dividend. It is difficult for a company to control the value of its stock, which is a reflection of the value that the marketplace places on a company. Essentially, stock price is the market’s evaluation of a company’s potential to produce earnings in the future. While Pontrelli Recycling, Inc. cannot directly control the price of its stock, it can, in large part, control its ability to produce earnings in the future.

In regard to planning an operational budget for a given year; financial managers must first make decisions about the company’s financial and other objectives and then decide how to make those decisions a reality through operations. Managers use information such as the financial ratios to make the decisions and then employ those ratios as they operate the company to see if they are producing the intended results.

If Pontrelli Recycling, Inc.’s management would like to increase value, then they must convince the market that they are capable of producing income in the future. There are many factors in producing income, including the company’s internal capacities, but there are also external influences, such as the condition of the market and competition. How a company responds to all of the influences will dictate its results. During a strong, expanding economy, the company that does not invest and increase capacity may lose out. During a weak or contracting economy, the company that overestimates its ability to expand may be the loser.

Let’s return to Pontrelli Recycling, Inc.’s financial ratios to see how the information can inform decision making. Certainly, profit margin can be improved by decreasing cost or improving efficiency without increasing revenues. If Pontrelli Recycling, Inc. were to decrease its cost of sales by $500,000, for example, it would increase its net profit margin to 5.4% and thus improve its return on equity to 50.8%. In other words, for every dollar of equity, the company would be producing 50.8% cents of net income. That represents a 14.5% increase in return on equity. The marketplace would normally notice such an increase.

Although the marketplace normally notices such an increase, if a competitor of Pontrelli Recycling, Inc.’s announces that it has implemented technology and processes to increase efficiency and widen the number of recyclable products, there could be a negative effect on Pontrelli’s stock, despite the company’s increased efficiency.

In addition to increasing value, Pontrelli Recycling, Inc. increases its annual dividend to shareholders. That dividend must come from somewhere. If the company increases efficiency and does not increase spending, it probably will also have an increase in cash on hand at the end of the year. One of the ways that Pontrelli Recycling, Inc. could deal with that cash is by giving more of it to the stockholders as a dividend. However, in order to maintain the increased dividend in the future, the gains in efficiency must be enduring, and revenues must also increase year over year.

So, Pontrelli Recycling, Inc. must decide now how to meet its financial objectives. There are a number of ways to do this. We have already discussed increased efficiency to improve profit margin, but there are others. The company could also increase revenues; however, increased revenues without increased efficiency will increase the amount of profits but not the underlying financial ratios. Increased income with the same profit margin will not affect ratios at all.

If Pontrelli Recycling, Inc. wishes to pursue new technology that will allow it to increase efficiency and expand the range of materials that can be recycled, there will without doubt be increased expenditures. Therefore, the company’s managers must look at all of the different aspects of the increased spending to try to decide whether to move ahead. On one hand, they must try and predict what effect the investment will have in revenue: for example, how many more clients do they believe that they will be able to acquire over a given time period in order to increase revenue? How much revenue will they be able to predict from existing clients due to additional materials that they will be able to recycle?

On the other hand, expenditures must be made in order to create the new capabilities. Some will be capital expenditures, equipment purchases, and construction of new plants or refurbishing of old plants. Pontrelli Recycling, Inc. may have to purchase new trucks and even provide new containers for clients. Capital expenditures must be amortized over a certain number of years. The manner in which capital expenditures are financed must also be considered. Will they be financed by debt or equity? Managers must review the cost of each and the affect on each of the ratios.

In addition to capital expenditures, there may be other costs to consider. For example, new equipment and processes probably will result in a need for staff training, which is not a cost that can be amortized over a period of years. Increased current costs will affect net profit, so managers must be decide if the increased cost will be offset by increased revenues during a time period that will allow them to pay the increased dividends to shareholders.

In order to create an operational budget, managers must look beyond the special project. They must also determine what amounts must be budgeted to provide for operations during the year. These amounts would include operations and any other one-time projects that must be considered. In the example of Pontrelli Recycling, Inc., a significant increase in the number of clients and volume of business could have other ramifications. For example, the company might need to hire more workers to man an increased number of trucks. The decision might include several options: Is it more cost effective to have trucks and workers work overtime to cope with the increase or to purchase additional vehicles and hire new workers?

The addition of more clients and consequently more workers may have other ramifications. Perhaps Pontrelli Recycling, Inc. will need to upgrade its accounting system to process an increase in billing and collections or install a new payroll system to handle the increased number of workers. The new technology may provide new client opportunities. Clients may seek assistance in developing new procedures to handle the increased materials. This could represent new revenue stream as well as new project costs.