MEMO
Date:
To: Initech Limited
From: XYZ Consultant
Re: Appraisal decisions of capital investment relating to tow proposals
As a consulting company, we would like to express our acknowledgment for selecting us in taking capital appraisal investment decisions regarding your two business proposals. Since you have sought advice from us regarding the two proposals, we have performed in depth analysis that is depicted and analyzed in table below.
For analyzing the two projects, techniques of capital budgeting have been applied by us. We have applied the concept of Net present value (NPV) for assessing the viability of the two projects. NPV is presented as the difference between present value of future cash flow by discounting it using a appropriate rate of return and the initial investment made by the company (Frank and Pamela 2016). Following formula is used for calculating NPV of two projects based on information provided by you.
NPV= ∑ Pt/ (1+c)t – Po
Where, Po is the initial capital investment made by company
Pt represents the cash flow at period t
C represents the Cost of capital or the required rate of return
t represents the time period of project
Criteria of accepting the project as per NVP rule:
As per the criteria, a project is accepted if it has generated positive NVP and if the project has generated negative NPV, it will be rejected and project with zero NPV will make the investor indifferent.
Now, considering the first investment proposal of device part project, it can be clearly depicted from the table that it has generated positive net present value. Therefore, this project of device part should be accepted as per the rule of NPV. Now, considering the detailed analysis of second project of installing the conveyer system, it can be seen that NPV of system A of the project has generated positive NPV when compared to other system that is B and C. System B and C has generated negative NPV and hence, these two system should be rejected.
Project 1:
|
Net Present Value of the Project: |
||||||
|
PERIOD |
||||||
|
Particulars |
0 |
1 |
2 |
3 |
4 |
5 |
|
Cost of New Plant & Equipment |
($8,00,000) |
|||||
|
Initial Working Capital |
($4,00,000) |
|||||
|
Initial Investment |
($12,00,000) |
|||||
|
Sales Growth Rate |
$0 |
$0 |
$0 |
$0 |
($0) |
($0) |
|
Annual Sales |
$40,00,000 |
$44,00,000 |
$48,40,000 |
$41,14,000 |
$34,96,900 |
|
|
Variable Costs |
($20,00,000) |
($22,00,000) |
($24,20,000) |
($20,57,000) |
($17,48,450) |
|
|
Depreciation on Plant & Equipment |
($80,000) |
($80,000) |
($80,000) |
($80,000) |
($80,000) |
|
|
Building Rental,Fixed Salaries & Other Fixed Costs |
($15,00,000) |
($15,30,000) |
($15,60,600) |
($15,91,812) |
($16,23,648) |
|
|
Net Profit before Tax |
$0 |
$4,20,000 |
$5,90,000 |
$7,79,400 |
$3,85,188 |
$44,802 |
|
Less: Income Tax |
($1,26,000) |
($1,77,000) |
($2,33,820) |
($1,15,556) |
($13,441) |
|
|
Net Profit after Tax |
$0 |
$2,94,000 |
$4,13,000 |
$5,45,580 |
$2,69,632 |
$31,361 |
|
Add: Depreciation |
$80,000 |
$80,000 |
$80,000 |
$80,000 |
$80,000 |
|
|
Add: Additional after-tax Profits |
$1,50,000 |
$1,50,000 |
$1,50,000 |
$1,50,000 |
$1,50,000 |
|
|
Net Operating Cash Flow |
$0 |
$5,24,000 |
$6,43,000 |
$7,75,580 |
$4,99,632 |
$2,61,361 |
|
Residual Value of Plant & Equipment |
$2,00,000 |
|||||
|
Less: Tax on Sales |
($60,000) |
|||||
|
Net Residual Value |
$1,40,000 |
|||||
|
Recovery of Net Working Capital |
$4,00,000 |
|||||
|
Terminal Value |
$5,40,000 |
|||||
|
Annual Cash Flow |
($12,00,000) |
$5,24,000 |
$6,43,000 |
$7,75,580 |
$4,99,632 |
$8,01,361 |
|
Cost of Capital |
$0 |
$0 |
$0 |
$0 |
$0 |
$0 |
|
Discounted Cash Flow |
($12,00,000) |
$4,59,649 |
$4,94,768 |
$5,23,494 |
$2,95,822 |
$4,16,202 |
|
Net Present Value |
$9,89,935 |
|
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) |
($1,30,000) |
($1,30,000) |
|
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) |
($1,20,728) |
Part A:
Description of average risk capital budgeting project of RFG:
For discussing this part of assignment, an ASX listed company named Retail food group has been selected by the researcher. In this section, the qualitative analysis of the project has been done. RFG has been planning to undertake project of expanding its business by opening few stores outside its home country that is in East Africa and in United Kingdom. RFG has assumed the duration of project to be of eight years for assessing the risk using the process and techniques of capital budgeting. The appropriate discounting factor has been used for assessing the risk.
One parameter that is used to assess the riskiness is use of discounting factor. A project is considered risky if for calculating the future cash flow, higher discounting factor is used. If the organization uses lower discounting factor for computing the future cash flow, the project is considered less risky. If RFG make more use of debt in its capital structure, the degree of financial leverage is considered to be high. The project will have uncertain future cash flow if the degree of financial leverage is high as they would be required to clear their debt obligations.
Working capital management is represented as the difference between current assets and current liabilities.
Current assets for financial year 2015 = $ 90182000
Current assets for financial year 2016 = $ 87244000
Current liabilities for financial year 2015 = $ 97025000
Current liabilities for financial year 2016 = $ 46832000
Working capital for financial year 2015 = – $ 6843000
Working capital for financial year 2016 = $ 40412000
From the above figures, it is evident that the working capital of RFG for the financial year 2015 is negative and it is indicative of the fact that short term obligations is not met by using its current assets. On the other hand, the first half of financial year generates positive working capital and it indicates that enough money is generated by using current assets for meeting their short term obligations.
The cash conversion cycle of organization is not efficient in the year 2015 as there is negative working capital. On the other hand, the cash conversion cycle is efficient and it indicates that RFG is efficiently converting its inventory into cash by making sales to meet short term obligations.
Part a:
Telstra Corporation will have more liquid assets available by using the commercial paper. The credit worthiness of the organization would improve while incorporating commercial paper in terms of its financing the activities. The risk of default by company on meeting its debt obligation is reduced by using the commercial paper and they are perceived to get higher credit rating (Lasher 2013).
Part b: Financial policy of Telstra Corporation
It is evident from the annual report of Telstra Corporation that there is high proportion of debt in the capital structure of the company. The applied financing methods are used for attaining the flexibility and maximizing the value to shareholders. Debt to equity ratio of the company stood at 121.2% and ratio of debt to capital employed stood at 53.99% in the financial year 2016. The financial policy of the company has influenced their profitability and has made the management more effective. It is required by the organization to have balance between using the bet and equity in its capital structure. The credit risk of Telstra Corporation has significantly improves by employing commercial paper for financing its activities.
References
Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory & practice. Cengage Learning.
Frank, J.F. and Pamela, P.P., 2016. Financial Management and Analysis.
Lasher, W.R., 2013. Practical 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.
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