Assumptions And Estimations For Investment Proposal Evaluation

Break even analysis

In order to evaluate an investment proposal, it is necessary that all sufficient data be collected and arranged. This data is then used to understand the possible outcomes if the investment is proceeded with.

To understand the outcomes of the new venture for Benjamin, using the financial data so collected. The data has been used to understand the investments made cash flows in the venture, profitability and other important issues relating to investment appraisal.

There are various costing and accounting tools which can be used to evaluate an investment proposal. Using few of such concepts in order to determine the profitability and possibility of undertaking the desired proposal for investment in retailing of gourmet chocolates. The following analysis contains profitability analysis, cash flow analysis and implementation of few of the capital budgeting decisions which has assisted in taking the correct decision.   

While evaluating s proposal based on financial information, seeing that there is a lot of information required which might not be easily available. In such cases to various approximations based on assumptions and market trend are made so that the analysis can be smoothly conducted.

Few of such assumptions and estimates have also been made in the following analysis, which has been listed below:

• Assumed that out of 1.7 million NOK, only 700,000 NOK has been invested in the business. This indicates that that the capital invested is 1200000 NOK.
• The purchase of chocolates from Sprindt and Lungi (S&L) are made in foreign currency, Swiss Franc, whereas the home currency is Norwegian Krone. In order to evaluate the purchase price needed to convert the foreign currency into home currency using the exchange rates which exist at the time of transaction. Since, this rate cannot be determined beforehand assuming the rate of 8.42 NOK per CHF for evaluation of the proposal for the next five years.
• The courier cost incurred for transport of the chocolate have been also converted using the same exchange rate.
• Any transaction costs which would be incurred necessary for the above transaction have been totally ignored.
• All the assets purchased and invested in have been assumed to have no salvage value and have been depreciated fully over the period of five years.
• The sale units for each month in the year one have been based on approximation increase in units sold In order to achieve the desired level of 420 kg.
• Assuming that the expenditure made on research for market study is a no- deductible expense for tax purposes and hence has not been written off.
• Any factors influencing the economy such as inflation have not been taken into consideration to evaluate this proposal
• The required rate of return in order to evaluate the investment decision has been taken as 3% which is the return earned on extra re-invested cash. Also, the surplus cash generated if any has not been assumed to have been reinvested, they are assumed to have been used in the business.

Therefore, these are few assumptions and estimates which have been made in order to evaluate the decision of invest in the new venture. 

A break-even point is the point at which the costs incurred are equal to the revenues such that the investor is neither at a profit nor at a loss. Break even analysis is a very important costing tool which helps the management set goals such that all the costs being incurred can be earned and also any revenues earned beyond that point will contribute to the profits of the company (Atkinson 2012).

Having calculated the break even for the said proposal of Benjamin which will helps understand the minimum level of units which are required to ®be sold each year every year in order to recover the initial invested amount along with annual fixed costs.

The breakeven point for sales has been separately calculated for internet sales and chocolate boxes separately.

In order to calculate the breakeven point there is required to calculate the contribution per unit and fixed costs, which have been provided separately for both the segments:

Particulars	Internet Sales	Chocolate Boxes
Sales Price	750	220
Less:
– Purchase price of Chocolates	437	109
– Courier Cost	80	20
– Packaging expense	50	–
– Credit card charges	9	–
– Decorative Boxes	–	40
Contribution	174	51
Fixed Cost
– Rent	86,400	–
– Employee Expenses	160,000	–
– Assistant’s Salary	–	50,400
– Depreciation	26,000	3,000
Total Fixed Cost	272,400	53,400

Also, contribution is calculated by subtracting the variable cost from the sales price per unit (Berry 2009).

The following is to be taken note of for the above contribution calculation:

• Courier expenses are incurred in connection with purchase of chocolates and hence are variable cost for both the internet sales and the chocolate boxes.
• Packaging and credit card charges are incurred only in connection with internet sales and hence are variable cost for internet sales only
• The expenses on decorative boxes are only related to sale of chocolate boxes and hence are only a part of variable cost of chocolate boxes.
• The depreciation for both the segments has been calculated as per the assets belonging to each segment. For internet sales there are the assets of 130000 NOK and for that of chocolate boxes are 15000NOK, which provides with the depreciation of 26000 NOK and 3000 NOK respectively.

The breakeven point is calculated by dividing the total fixed cost by contribution per unit (Boyd 2013). Using this data results in the following:

Particulars	Internet Sales	Chocolate Boxes
Contribution	174	51
Total Fixed Cost	272,400	53,400
Break Even Point (units)	1,567	1,051

Therefore the break even sales unit for internet sales is 1567 Kg of chocolates and that for chocolate boxes are 1051 boxes.

Any sales made above the stated breakeven level the business will earn profits. The above levels indicate the minimum level of sales to be achieved in order to avoid incurring of losses.

Following is the projected profit statement along with the balance sheet of the business of the first year of operations:

Statement of Profit and Loss
Particulars	Amount
Revenues- Internet Sales	1,965,000
Revenues- Chocolate Boxes	264,000
Less:
– Purchase price of Chocolates	-1,405,617
– Courier Cost	-258,486
– Packaging expense	-261,916
– Rent	-86,400
– Credit card charges	-24,563
– Employee Expenses	-160,000
– Assistant’s Salary	-50,400
– Depreciation	-29,000
– Decorative Boxes	-48,000
Profit Before taxes	-95,381
– Taxes (35%)	33,383
Profit after tax	-61,998

Profit and Loss and balance sheet for year one of investment

The business will not earn sufficient profits in the first year of its being in operation. The reason being low units sold. The research made before the initiation of the operations show that the business is expected to sell only 50 kilograms of chocolates in the first month of its operation, which gradually increases to 420 kilograms of chocolates per month from year 2. Since the business is new and requires time to build up a reputation, the first year of the business has not been earning sufficient profits.

The projected balance sheet at the end of year one of the businesses has also been presented below:

Balance Sheet
Assets	Amount	Amount
Fixed assets
Refrigerator	55,000
Less: Depreciation	11,000	44,000
Website	75,000
Less: Depreciation	15,000	60,000
Wrapping Machine	15,000
Less: Depreciation	3,000	12,000
Current Assets
Deposit for rent		21,600
Rent paid in advance		7,200
Advance payment for purchases		205,168
Advance payment for Courier charges		37,729
Deferred expense-Research		50,000
Revenue receivable		311,063
Cash		389,243
Total Assets		1,138,002
Liabilities
Capital
Capital	1,200,000
Add: Profit for the year	-61,998	1,138,002
Total Liabilities		1,138,002

Calculation of Closing cash balance
Particulars	Amount
Opening capital introduced	1,200,000
Adjustment for:
Cash flow for the year	-535,277
Assets invested in	-145,000
Deposit for rent	-21,600
Payment made for purchases in advance	-43,653
Courier charges paid for in advance	-8,028
Rent paid in advance	-7,200
Research expenses	-50,000
Closing cash balance	389,243

The cash balance at the end of the year is 389243 NOK, this will be sufficient to run the business in the next year. In case there is shortfall of cash, further cash can be introduced as capital in the business.

Following represents the monthly cash flow of the business for the first year of its operations:

Sales data	1	2	3	4	5	6	7	8	9	10	11	12	Year 1
Internet Sales
Sales price per unit	750	750	750	750	750	750	750	750	750	750	750	750	750
Unit sales	50	80	110	140	170	200	230	260	290	320	350	420	2,620
Chocolate Boxes
Sales price per unit	220	220	220	220	220	220	220	220	220	220	220	220	220
Unit sales	100	100	100	100	100	100	100	100	100	100	100	100	1,200
Net income	1	2	3	4	5	6	7	8	9	10	11	12	Year 1
Revenues- Internet Sales	–	37,500	60,000	82,500	105,000	127,500	150,000	172,500	195,000	217,500	240,000	262,500	1,650,000
Revenues- Chocolate Boxes	22,000	22,000	22,000	22,000	22,000	22,000	22,000	22,000	22,000	22,000	22,000	22,000	264,000
– Purchase price of Chocolates	-56,749	-69,844	-82,940	-96,036	-109,132	-122,228	-135,323	-148,419	-161,515	-174,611	-205,168	-205,168	-1,567,132
– Courier Cost	-10,436	-12,844	-15,252	-17,661	-20,069	-22,477	-24,885	-27,294	-29,702	-32,110	-37,729	-37,729	-288,187
– Packaging expense	-21,826	-21,826	-21,826	-21,826	-21,826	-21,826	-21,826	-21,826	-21,826	-21,826	-21,826	-21,826	-261,916
– Rent	-7,200	-7,200	-7,200	-7,200	-7,200	-7,200	-7,200	-7,200	-7,200	-7,200	-7,200	-7,200	-86,400
– Credit card charges	–	-469	-750	-1,031	-1,313	-1,594	-1,875	-2,156	-2,438	-2,719	-3,000	-3,281	-20,625
– Employee Expenses	-13,333	-13,333	-13,333	-13,333	-13,333	-13,333	-13,333	-13,333	-13,333	-13,333	-13,333	-13,333	-160,000
– Assistant’s Salary	-4,200	-4,200	-4,200	-4,200	-4,200	-4,200	-4,200	-4,200	-4,200	-4,200	-4,200	-4,200	-50,400
– Decorative Boxes	-4,000	-4,000	-4,000	-4,000	-4,000	-4,000	-4,000	-4,000	-4,000	-4,000	-4,000	-4,000	-48,000
– Taxes	15,969	13,619	11,269	8,918	6,568	4,218	1,868	-482	-2,832	-5,182	-7,533	-13,016	33,383
Cash Flow after tax	-79,775	-60,598	-56,233	-51,869	-47,504	-43,140	-38,775	-34,411	-30,046	-25,682	-41,989	-25,254	-535,277

In the first year of the operation, the business has negative cash flows. This is due to the reason that the sales are low in year one. The fixed cost incurred is irrespective of units (Holtzman 2013). Hence, due to high costs and lower revenues in year one of operation results in negative cash flows.

Besides the above the following cash investments are also required to be made in order to start-up the business:

Investment in fixed assets	-145,000
Research cost	-50,000
Deposit for Rent	-21,600
Purchase of Material one month in advance	-43,653
Courier charges	-8,028
Adjustment for rent paid in advance	-7,200
Cash flow after tax
Net cash flows	-275,480

The above cash flows have been prepared keeping in mind that the revenues earned in the current month are received for in the next month net of credit card charges. Also, that all expense is paid for in the month in which they are incurred, except for purchases and courier charges which are paid for one month in advance.  

The following is the projected annual cash flow statement for the next five years:

Sales data	Year 1	Year 2	Year 3	Year 4	Year 5
Internet Sales
Sales price per unit	750	750	750	750	750
Unit sales	2,620	5,040	5,040	5,040	5,040
Chocolate Boxes
Sales price per unit	220	220	220	220	220
Unit sales	1,200	1,200	1,200	1,200	1,200
Net income	Year 1	Year 2	Year 3	Year 4	Year 5
Revenues- Internet Sales	1,650,000	3,780,000	3,780,000	3,780,000	3,780,000
Revenues- Chocolate Boxes	264,000	264,000	264,000	264,000	264,000
– Purchase price of Chocolates	-1,567,132	-2,462,012	-2,462,012	-2,462,012	-2,256,845
– Courier Cost	-288,187	-452,751	-452,751	-452,751	-415,022
– Packaging expense	-261,916	-261,916	-261,916	-261,916	-261,916
– Rent	-86,400	-86,400	-86,400	-86,400	-79,200
– Credit card charges	-20,625	-47,250	-47,250	-47,250	-47,250
– Employee Expenses	-160,000	-160,000	-160,000	-160,000	-160,000
– Assistant’s Salary	-50,400	-50,400	-50,400	-50,400	-50,400
– Decorative Boxes	-48,000	-48,000	-48,000	-48,000	-48,000
– Taxes	33,383	-156,195	-156,195	-156,195	-156,195
Cash Flow after tax	-535,277	319,076	319,076	319,076	569,173

In the calculation of the cash flows there are excluded the non-cash expense such as depreciation. Also, the tax expense has been deducted from the cash flows after calculating the profits after depreciation.

From the above it can be seen that the venture has been earning positive cash flows from the second year of its operations. The increase in the cash flows from year one has been result of higher units being sold in the market. 

In order to start up a venture it is necessary that fund be available for investments in the necessary assets (Horngren 2012). For the given venture of retail sale of chocolates there is estimated the following amount is required for initial investment in the project:

Particulars	Amount
Investment in fixed assets	-145,000
Research cost	-50,000
Deposit for Rent	-21,600
Purchase of Material one month in advance	-43,653
Courier charges	-8,028
Adjustment for rent paid in advance	-7,200
Cash flow after tax
Net cash flows	-275,480

The above assets are required to be purchased and invested in before the operations of the business start. All the expenses incurred are necessary for initial start-up of the business operations. Therefore the venture will require a minimum of 275480 NOK to get started.  

In the above discussion having discussed about the cash flows and profit of the venture. But in order to evaluate an investment decision it is impotent that further financial analysis be done of the collected data (Piper 2015).

Monthly cash flow of the business for the first year of operations

Having conducted a capital budgeting analysis of the said investment proposal in order to evaluate the profitability of the venture taking into consideration the concept of time value of money.

• Net present value

Net present value is the capital budgeting tool that helps calculate the present value of the cash flows that are expected to be generated form a venture. The net present value is calculated by subtracting the present values of the cash inflows with that of the cash outflows (Seal 2012). If the net present value is positive, it indicates investment appraisal and hence should be accepted. In the net present value is negative the project should be declined. In order to calculate the present values there have been used the discount rate of 3%, which the current return earned on investments.

The net present value of the said venture as positive 596,904 NOK.

Since the project has positive net present value, the project is viable and should be accepted.

• Internal rate of return

Internal rate of return is the actual rate of return earned on the project. This is calculated by equating the cash inflows and cash outflows in order to calculate the hidden rate of interest (Siciliano 2015). If the internal rate of return is higher than the actual rate of return then it indicates higher returns than accepted. The project should be accepted if the internal rate of return is equal to or higher than the required rate of return.

For the given venture the required rate of return is 3% and the internal rate of return is 24%. Since the internal rate of return is higher than the required rate, the project should be accepted.

• Payback period

Payback period is the period in which the invested amount is recovered by the investor. Any revenues earned beyond this point are the cash flows earned above the invested amount (Simpson 2012). The project with lower payback period should be accepted.

The payback period for the given venture is 3.54 years. The investor will start earning profits after 3.54 years, this seems reasonable time for recovery of invested amount, and hence project should be accepted.

• Profitability index

Profitability index is another tool of capital budgeting process which helps calculate the profits generated per unit of investment made. If the profitability index is one or more than one the project should be accepted.

For the given venture the profitability index is 3.17 times. This indicates that for every NOK invested in the business the investor will earn 3.15 NOK. Since the profitability index is more than one, the project seems viable and should be accepted.

From the above analysis of the financial data it can be seen that the project is likely to generate profits if the said assumptions hold good. Hence, based on such analysis the venture proposal must be accepted. 

Sensitivity analysis is yet another part of capital budgeting analysis which helps understand the effect on outcomes of an investment proposal if changes in the inputs of the same proposal are made. Therefore, sensitivity analysis helps analysis the sensitivity of the output with respect to the changes in the input.

Having conducted the sensitivity analysis of the above said proposal and have come up with the following results:

• Sensitivity of the result with respect to selling price

Having calculated the effect of changes in the net present value, profitability index, payback period and internal rate of return with one percent increase in the selling price of the product. There is the following:

Particulars	Result	Base Case	Difference	% change
Payback period	2.33	years	3.54	-1.21	-34.08
Profitability index	4.84	times	3.17	1.67	52.88
Net Present Value (NPV)	1,058,221		596,903.90	461,316.82	77.28
Internal Rate of return	51%		0.24	0.27	109.73

Therefore, with one percent increase in the sale price of the product the net present value of the project increases by up to 78% that is the net present value increases to 1058221 NOK from 596904 NOK. Also the profitability index increases from 3.17 times to 4.84 times which is increase by 53%, internal rate of return increases over 110% and the payback period declines by 34%.

Hence the outcomes are highly sensitive to the selling price of the product.

• Sensitivity of the result with respect to purchase price

Having  calculated the effect of changes in the net present value, profitability index, payback period and internal rate of return with one percent increase in the purchase price of the product. There is the following:

Particulars	Result	Base Case	Difference	% change
Payback period	3.81	years	3.54	0.27	7.50
Profitability index	2.80	times	3.17	-0.37	-11.73
Net Present Value (NPV)	494,609		596,903.90	-102,295.00	-17.14
Internal Rate of return	21%		0.24	-0.04	-14.96

From the above calculations, the one percent increase in the purchase price of the chocolates will decline the net present value to 494609 NOK, which is 17% lower than the base case. Also, the increase in cost price will decline the profitability index by 12% and internal rate of return by 15%. The payback period of the proposal will increase to 3.81 years from 3.54 years which is approximately 8% higher than the base case.

Therefore, seeing that the purchase price of the chocolates will affect the outcomes of the investment opportunity, but the effect will not be as volatile as the changes in the selling price.

• Sensitivity of the result with respect to required rate of return

Having calculated the effect of changes in the net present value, profitability index, payback period and internal rate of return with one percent increase in the required tae of return with which the cash flows are discounted. There is the following:

Particulars	Result	Base Case	Difference	% change
Payback period	3.54	years	3.54	–	–
Profitability index	3.16	times	3.17	-0.00	-0.16
Net Present Value (NPV)	595,545		596,903.90	-1,359.38	-0.23
Internal Rate of return	24%		0.24	–	–

The increase in the required rate of return from 3% to 3.03% has affected the net present value of the venture. The net present value of the said investment proposal was 596093 NOK under 3% and it has declined to 595545 NOK with one percent increase in the required rate of return. Therefore one percent increase in the required rate of return has resulted in 0.23% decline in the net present value

Hence the output of the project is not as sensitive to the required rate of return as compared to the others factors. 

Non- Financial factors to be considered in evaluation of investment proposal

The above discussion lay out the conclusion on acceptance of the venture proposal based on financial analysis. But in order to make the correct decision it is important that necessary non- financial factors be also taken into consideration. Few of such non-financial factors shave been listed below:

• Difficulty in estimation: calculation of the required rate of return in not an easy task. The required rate of return should be such that it included all the necessary factors such as return and risk. This required rate cannot be same under all the circumstances, hence this should be calculated with due care and diligence
• Changes in the regulations: it is possible that the regulations under which the project is being executed currently might change in the future. Such changes may have positive or negative impact on the outcomes. Hence there is always a possibility of this change which might affect out decision in the future. For example, the chocolates to be sold in the current scenario are being imported; changes in the regulation may restrict such import which will affect the investment decision.
• Changes in the economy: any minor changes in the economy might have a major impact on the business. All the factors of a business are related to the economy. The ups and downs are to affect the projected results of the investment proposal. 

In order to obtain the exclusive rights to sell the chocolates by S&L, it is required to pay an upfront fee for purchase of such rights. The value of such rights is required to be paid up front. Hence, the value of the right cannot be more than the net present value of the cash flows earned and calculated as above, which is 596,904 NOK.

If the value of the upfront fee is more than the net present value of the venture, then the venture will incur losses, it would be better to not proceed with the venture if the fee is more than the specified amount. The fee paid should be such that the revenues expected to earn can generate profits over all the costs. Hence the value of the upfront fee for the exclusive rights for purchase of chocolates should not exceed 5896,904 NOK. 

The above discussion has helped understand a lot of financial factors of the proposed venture. The cash flows, profits and detailed capital budgeting analysis of the above proposal have provided with an insight into the working of the venture. The above analysis suggests that the venture should be accepted as it will generate profits for the investors in the long run.

While making the decision on acceptance or rejection of a proposal, there are various factors along with the financial factors which should be taken into consideration. The financial analysis always has the risk of uncertainty; any minor changes in the economy may result in volatile deviations from the expected results. The financial result cannot account for these uncertain risks.

The rate of return which is expected to earn on spare cash is 3%. If the said investment is made by the investor then he will earn amount 24% on his investment over the period of three years.

Hence, it is recommended that the investor to search for other options for investments which provide profits higher than the existing proposal. 

Conclusions and recommendations

The above analysis has helped have an insight into the possible outcome the said venture of retiling of gourmet chocolates. The financial analysis made with the data available results in profit from the said venture. The project will generate profits for Uncle Benjamin and hence he should proceed with the investment in said venture. Also, it would be okay if the investor will not pay for the exclusive rights of the sale of chocolates. This is so because; even without the exclusive rights the venture is expected to earn high profits. Therefore, the payment for exclusive rights should be made only if increases the sales to such extent which will earn the venture net value higher than current level. 

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