To: Initech
Re: Decision concerning appraisal of capital investment
We as a consultant company would like to express our deep gratitude for providing us with the opportunity so that we can work on the appraisal decision of capital investment made by you. We have been provided with two types projects relating to device part and conveyer system. The detailed analysis of two proposals presented by you will be analyzed in detail for making the recommendation for acceptance of suitable project. Detailed analysis has been depicted in below section.
The two given projects of device part and conveyer system has been analyzed using the technique of capital budgeting. The capital budgeting tool of Net present value has been implemented for analyzing the project. For calculating the net present value of project, we have considered the present value of future cash flow and the amount of capital initially invested in project. This project helps in determining the likelihood of accepting the project based on profit generation. We have assumed that bot the projects would generate returns in equal amount throughout the project life. Based on the assumption, following formula have been used for calculating the net present value of project.
Net present value = ∑ = Vt/ (1+k)t– Vo
Where K stands for required or expected rate of return
t stands for time duration of project
Vo stands for initial capita investment made by Initech
Vt stands for flow of cash for period t
The criteria for accepting the project depends upon whether projects are standalone or they are mutually exclusive. If the projects were mutually exclusive, then the projects generating higher net present value would be accepted. On other hand, standalone project will be accepted if the value of NPV is positive, it will be rejected, if NPV is negative and the investor would remain indifferent between the projects if project valuation generates zero NPV (Hise and Strawser 2013).
Now, considering the first project of Initech that is project of device part, it can be seen that net present value of this particular project is positive. As per the decision, Initech should accept rule of NPV this project. The second proposed project of Conveyer system will be rejected. This is depicted by negative NPV of this project as presented in the table. Therefore, as per the acceptance criteria of net present valuation technique, it is viable to accept first project and reject second project (Madura 2014). However, some other aspects needs to be considered by investors while making investment decisions.
|
Net Present Value of the Devise Part Project: |
||||||
|
Period |
||||||
|
Particulars |
0 |
1 |
2 |
3 |
4 |
5 |
|
Cost of New Plant & Equipment |
($800,000) |
|||||
|
Initial Working Capital |
($400,000) |
|||||
|
Initial Investment |
($1,200,000) |
|||||
|
Sales Growth Rate |
0.00% |
0.00% |
10.00% |
10.00% |
-15.00% |
-15.00% |
|
Annual Sales |
$4,000,000 |
$4,400,000 |
$4,840,000 |
$4,114,000 |
$3,496,900 |
|
|
Variable Costs |
($2,000,000) |
($2,200,000) |
($2,420,000) |
($2,057,000) |
($1,748,450) |
|
|
Depreciation on Plant & Equipment |
($80,000) |
($80,000) |
($80,000) |
($80,000) |
($80,000) |
|
|
Building Rental,Fixed Salaries & Other Fixed Costs |
($1,500,000) |
($1,530,000) |
($1,560,600) |
($1,591,812) |
($1,623,648) |
|
|
Net Profit before Tax |
$0 |
$420,000 |
$590,000 |
$779,400 |
$385,188 |
$44,802 |
|
Less: Income Tax |
($126,000) |
($177,000) |
($233,820) |
($115,556) |
($13,441) |
|
|
Net Profit after Tax |
$0 |
$294,000 |
$413,000 |
$545,580 |
$269,632 |
$31,361 |
|
Add: Depreciation |
$80,000 |
$80,000 |
$80,000 |
$80,000 |
$80,000 |
|
|
Add: Additional after-tax Profits |
$150,000 |
$150,000 |
$150,000 |
$150,000 |
$150,000 |
|
|
Net Operating Cash Flow |
$0 |
$524,000 |
$643,000 |
$775,580 |
$499,632 |
$261,361 |
|
Residual Value of Plant & Equipment |
$200,000 |
|||||
|
Less: Tax on Sales |
($60,000) |
|||||
|
Net Residual Value |
$140,000 |
|||||
|
Recovery of Net Working Capital |
$400,000 |
|||||
|
Terminal Value |
$540,000 |
|||||
|
Annual Cash Flow |
($1,200,000) |
$524,000 |
$643,000 |
$775,580 |
$499,632 |
$801,361 |
|
Cost of Capital |
$0 |
$0 |
$0 |
$0 |
$0 |
$0 |
|
Discounted Cash Flow |
($1,200,000) |
$459,649 |
$494,768 |
$523,494 |
$295,822 |
$416,202 |
|
Net Present Value |
$989,935 |
|
Net Present Value of Conveyer System: |
|||||||
|
Particulars |
Period |
System A |
System B |
System C |
|||
|
Total |
Discounted |
Total |
Discounted |
Total |
Discounted |
||
|
Cost of Capital |
14% |
14% |
14% |
||||
|
Initial Investment |
0 |
($40,000) |
($40,000) |
($55,000) |
($55,000) |
($130,000) |
($130,000) |
|
Annual Cash Flow |
1 |
$13,000 |
$11,404 |
$9,000 |
$7,895 |
$1,400 |
$1,228 |
|
Annual Cash Flow |
2 |
$13,000 |
$10,003 |
$9,000 |
$6,925 |
$1,400 |
$1,077 |
|
Annual Cash Flow |
3 |
$13,000 |
$8,775 |
$9,000 |
$6,075 |
$1,400 |
$945 |
|
Annual Cash Flow |
4 |
$13,000 |
$7,697 |
$9,000 |
$5,329 |
$1,400 |
$829 |
|
Annual Cash Flow |
5 |
$13,000 |
$6,752 |
$9,000 |
$4,674 |
$1,400 |
$727 |
|
Annual Cash Flow |
6 |
$13,000 |
$5,923 |
$9,000 |
$4,100 |
$1,400 |
$638 |
|
Annual Cash Flow |
7 |
$13,000 |
$5,195 |
$9,000 |
$3,597 |
$1,400 |
$559 |
|
Annual Cash Flow |
8 |
$13,000 |
$4,557 |
$9,000 |
$3,155 |
$1,400 |
$491 |
|
Annual Cash Flow |
9 |
$13,000 |
$3,998 |
$9,000 |
$2,768 |
$1,400 |
$431 |
|
Annual Cash Flow |
10 |
$13,000 |
$3,507 |
$9,000 |
$2,428 |
$1,400 |
$378 |
|
Annual Cash Flow |
11 |
$1,400 |
$331 |
||||
|
Annual Cash Flow |
12 |
$1,400 |
$291 |
||||
|
Annual Cash Flow |
13 |
$1,400 |
$255 |
||||
|
Annual Cash Flow |
14 |
$1,400 |
$224 |
||||
|
Annual Cash Flow |
15 |
$1,400 |
$196 |
||||
|
Annual Cash Flow |
16 |
$1,400 |
$172 |
||||
|
Annual Cash Flow |
17 |
$1,400 |
$151 |
||||
|
Annual Cash Flow |
18 |
$1,400 |
$132 |
||||
|
Annual Cash Flow |
19 |
$1,400 |
$116 |
||||
|
Annual Cash Flow |
20 |
$1,400 |
$102 |
||||
|
Net Present Value |
$27,810 |
($8,055) |
($120,728) |
In order to analyze the risk of capital budgeting project of company, the company selected by researcher is Mantra Group limited. There is a new project undertaken by company regarding the expansion of its stores and divisions in two Western countries that is United Kingdom and South Africa. This would involve allocation of resources and determination of cash inflow and cash outflow that needs to be budgeted and planned over long period (Ahmed 2013). For undertaking of project, Mantra would need to be considered qualitative and quantitative issues. However, in this particular section, researcher would be performing qualitative analysis of projects that is undertaken.
For assessing the risk associated with the processing of capital budgeting, duration of project is considered by the organization. Project duration is assumed to be of ten years. Viability of project is measured by the application of procedure of capital budgeting. Risk associated with the project and whether it should be rejected or accepted is determined by using the capital budgeting technique.
Several parameters or variables are associated with any project. The future cash flow generated by the project is discounted using the required rate of return or cost of capital. The project is considered as risky project if higher discounting rate is involved in computation of future cash flow of project. On the other hand, project with lower discounting rate for calculating the future cash flow is considered less risky. Another factor that forms the basis of future cash flow of project undertaken by company is the degree of financial leverage. Financial leverage of any organization is considered to be high if the debt obligation tends to be high. Higher debt obligation would pose risk in generating future cash flow of the project (Karadag2015). This is so because the company would require meeting its debt obligation first.
The data for calculating the working capital for the Mantra Group limited for two financial year has been collected from annual report company available on its website. Difference between current assets and current liabilities represents the working capital management.
2015 2016
Current assets= $ 134185000 $ 177098000
Current liabilities= $ 89404000 $ 89342000
Working capital for financial year 2015= ($ 134185000- $ 89404000) = $ 44781000
Working capital for financial year 2016= ($ 177098000 – $ 89342000) = $ 87756000
The working capital for both the financial year that is 2015 and 2015 is positive. A positive working capital is always considered suitable than negative working capital. The working capital in the present year has increased as compared to previous year. This is indicative of the fact that current obligations of company is met by using their current obligations, as they are able to generate enough money from operations. The current growing operations of the company is sufficient to finance their own expansion (Annualreports.com 2017). Mantra Group limited is efficient enough in converting its inventory into sales for meeting its short-term debts.
The amount of working capital is quite large, the value has increased significantly compared to previous year, and it is evident that for the expansion of capital, Mantra is not required to make investors or take additional amount of debt.
The financing of operations of organization is done by issuing commercial paper. Using the commercial paper by Telstra corporation is indicative of the fact that there will be more liquid assets available to company in the future. Commercial paper will leads to increase in credit worthiness of company and enables high credit rating. It will assist the organization in getting credit enhancement as the perceived risk of making default on meeting the debt obligation is reduced. It is low cost alternative method employed by organization for financing its operations (Burns and Walker 2015). It will help the organization to improve its credit rating in the market.
The capital structure of company has more proportion of debt as compared to equity. Therefore, the capital structure is more debt oriented. Increase in financial leverage or higher degree of leverage will help in reducing the riskiness of the business of Telstra Corporation. There are three wide objectives of Telstra Corporation incorporated in the financial policy. This comprise of maintaining flexibility in terms of sing financing methods applied, generating more value to shareholders by maximization of value of their wealth (Titman et al. 2014). It is depicted from the figures of gearing ratio or leverage ratio. The figures of total debt to capital employed stood at 53.99% and the debt to equity ratio of Telstra Corporation stood at 121.2%.
Telstra Corporation debt to equity ratio:
(Source: created by author)
It is indicative of the fact that employment of commercial paper is making significant contribution to the structure of organization. The level of debt has relevance influence over the debt capital. Most of the organization give heavy weightage on financing its capital by issuing of equity. This is so because the organizations using higher proportion of equity in its capital structure will help in generating maximum return with higher level of risk. In this particular case of Telstra Corporation, the profitability of the organization has been influenced by the employment of such financial policy that has resulted in capital spending of the company at higher growth rate. Moreover, the effectiveness of management and its financial strength is also being influenced by the financial policy adopted. There is requirement of part of financial management of every business to have correct balance between using equity and debt in their capital structure. Proportion of debt and equity should be balanced that it helps in reducing the riskiness of capital structure of organization (Petty et al. 2015). Nonetheless, using commercial paper in the capital structure of Telstra Corporation is one of the significant component that would assist the reducing the credit risk.
Reference & Bibliography:
Ahmed, I.E., 2013. Factors determining the selection of capital budgeting techniques. Journal of Finance and Investment Analysis, 2(2), pp.77-88.
Annualreports.com. (2017). Mantra Group Ltd – AnnualReports.com. [online] Available at: https://www.annualreports.com/Company/Mantra-Group-Ltd [Accessed 2 May 2017].
Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory & practice. Cengage Learning.
Burns, R. and Walker, J., 2015. Capital budgeting surveys: the future is now.
Cavusgil, S.T., Knight, G., Riesenberger, J.R., Rammal, H.G. and Rose, E.L., 2014. International business. Pearson Australia.
Chan, K. and Rate, E.A.I., 2017. & 6 The Time Value of Money. Financial Management.
Hise, R.T. and Strawser, R.H., 2013. Application of Capital Budgeting Techniques to Marketing Operations. Readings in Managerial Economics: Pergamon International Library of Science, Technology, Engineering and Social Studies, p.419.
Karadag, H., 2015. Financial management challenges in small and medium-sized enterprises: A strategic management approach. Emerging Markets Journal, 5(1), p.26.
Lasher, W.R., 2013. Practical financial management. Nelson Education.
Madura, J., 2014. International financial management. Nelson Education.
Petty, J.W., Titman, S., Keown, A.J., Martin, P., Martin, J.D. and Burrow, M., 2015. Financial management: Principles and applications. Pearson Higher Education AU.
Titman, S., Martin, J.D. and Keown, A.J., 2014. Financial Management Principles.
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