Discuss about the FIN80005 Corporate Financial Management.
The present report is developed in order to demonstrate the importance of capital budgeting techniques used for evaluating the project feasibility. The process of capital budgeting is used for examining the long-term economic and financial profitability of the investment project. The capital investment projects to be selected by a business organization involve high financial risks and therefore the project manager adopts the use of capital budgeting technique for determining their potential feasibility (Peterson and Fabozzi, 2002). The use of various capital budgeting techniques such as net present value (NPV), internal rate of return (IRR), accounting rate of return (ARR), payback period and the present value index helps the project manager to conduct the systematic analysis of the projects (Bromwich and Bhimani, 2005). This helps in selection of the investment project that is associated with less risk and will provide higher returns to the company in future context. As such, the use of above mentioned capital budgeting techniques is used for evaluating the feasibility of the investment project planned to be undertaken by Branson Ltd (Higgins, 2012). The company is a publicly listed tour company of Melbourne involved in providing hot-air balloon flights to the tourists over the city. Branson Ltd is conserving the adoption of capital investment project for replacing their current balloons with a large or small model. As such, the company is required to evaluate the various scenarios for analyzing the capital replacement decision and thus selecting the best possible replacement option (Besley and Brigham, 2008).
The scenario involves replacing the current balloon with the new balloon and this potential investment option of the company is likely to incur it a cost of about $800,000 with an additional installation and shipping costs of $50,000. Also, there will be an additional requirement of net working capital of about $50,000 for the large model. The company in the period of high demand is expecting operating revenue of about $650,000 for the large model and in the condition of low demand it is estimated to be about $300,000. The annual variable and fixed costs that are associated with the operation of the large balloons are $30,000. However, the most important concern for the company is that if it selects the investment option of large model then it needs to rent an additional warehouse for storage purpose and thus will cost the company around $50,000 and it can realize about $400,000 by selling the large balloons in the condition of business not profitable. As such, the use of capital budgeting techniques will help in determining the feasibility of this investment option for determining whether it should be accepted or rejected (Bierman and Smidt, 2007).
This scenario analyses the investment option of selecting small model for replacement of current balloon by the company. The initial capital investment expected to be incurred with the selection of small model is about $500,000 and the installation cost will be about $30,000. The working capital requirement is of about $50,000 and the operating revenue expected to be realized is $300,000. The variable and fixed costs that will be incurred are $300,000 and in the condition of the option undertaken to be not profitable the small balloons can be sold for $80,000 (Bierman, 2012).
Calculation of WACC in order to find the discount rate
|
Debt Equity ratio |
1.50 |
|
|
Debt proportion |
0.60 |
|
|
Equity proportion |
0.40 |
|
|
Equity |
||
|
Average return on Company |
8.37% |
|
|
Average return on Market |
9.13% |
|
|
Average Risk free return |
4.84% |
|
|
Beta of Branson |
1.56 |
|
|
Cost of Equity |
11.54% |
|
|
Debentures |
||
|
Annual Coupon Rate |
10% |
|
|
Face Value |
$ 1,000.00 |
|
|
Duration |
5 |
years |
|
Similar Debenture yield |
12% |
|
|
Market Price of Debenture |
$ 833.33 |
|
|
Annual Coupon Rate |
$ 100.00 |
|
|
Annual Effective Rate |
8.40% |
|
Calculation of WACC |
|||
|
Capital |
Weights |
Rate AT |
Weighted Cost |
|
Debt Part |
0.60 |
8.40% |
5.04% |
|
Equity Part |
0.40 |
11.54% |
4.62% |
|
1.0000 |
9.66% |
Calculation for scenario 1: Small Size balloon
|
Particulars |
Year 0 |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
Year 7 |
Year 8 |
|
Probability |
|||||||||
|
High |
75% |
75% |
75% |
75% |
50% |
50% |
50% |
50% |
|
|
Low |
25% |
25% |
25% |
25% |
50% |
50% |
50% |
50% |
|
|
Operating Revenue In high demand |
$ 300,000 |
$ 300,000 |
$ 300,000 |
$ 300,000 |
$ 300,000 |
$ 300,000 |
$ 300,000 |
$ 300,000 |
|
|
Operating Revenue In low demand |
$ 150,000 |
$ 150,000 |
$ 150,000 |
$ 150,000 |
$ 150,000 |
$ 150,000 |
$ 150,000 |
$ 150,000 |
|
Particulars |
Year 0 |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
Year 7 |
Year 8 |
|
Cash Inflows |
|||||||||
|
Operating Sales Revenue (High Demand) |
$ 225,000 |
$ 225,000 |
$ 225,000 |
$ 225,000 |
$ 150,000 |
$ 150,000 |
$ 150,000 |
$ 150,000 |
|
|
Operating Sales Revenue Low Demand) |
$ 37,500 |
$ 37,500 |
$ 37,500 |
$ 37,500 |
$ 75,000 |
$ 75,000 |
$ 75,000 |
$ 75,000 |
|
|
Total Sales |
$ 262,500 |
$ 262,500 |
$ 262,500 |
$ 262,500 |
$ 225,000 |
$ 225,000 |
$ 225,000 |
$ 225,000 |
|
|
Less: |
|||||||||
|
Annual Variable and Fixed cost |
$ 120,000 |
$ 120,000 |
$ 120,000 |
$ 120,000 |
$ 120,000 |
$ 120,000 |
$ 120,000 |
$ 120,000 |
|
|
Depreciation |
$ 106,000 |
$ 84,800 |
$ 67,840 |
$ 54,272 |
$ 43,418 |
$ 34,734 |
$ 27,787 |
$ 22,230 |
|
|
Total |
$ 226,000 |
$ 204,800 |
$ 187,840 |
$ 174,272 |
$ 163,418 |
$ 154,734 |
$ 147,787 |
$ 142,230 |
|
|
Profit Before tax after dep |
$ 36,500 |
$ 57,700 |
$ 74,660 |
$ 88,228 |
$ 61,582 |
$ 70,266 |
$ 77,213 |
$ 82,770 |
|
|
Less: Tax |
$ 10,950 |
$ 17,310 |
$ 22,398 |
$ 26,468 |
$ 18,475 |
$ 21,080 |
$ 23,164 |
$ 24,831 |
|
|
Profit after tax after dep |
$ 25,550 |
$ 40,390 |
$ 52,262 |
$ 61,760 |
$ 43,108 |
$ 49,186 |
$ 54,049 |
$ 57,939 |
|
|
Add: Depreciation |
$ 106,000 |
$ 84,800 |
$ 67,840 |
$ 54,272 |
$ 43,418 |
$ 34,734 |
$ 27,787 |
$ 22,230 |
|
|
Profit before dep after tax |
$ 131,550 |
$ 125,190 |
$ 120,102 |
$ 116,032 |
$ 86,525 |
$ 83,920 |
$ 81,836 |
$ 80,169 |
|
|
Salvage of Balloon |
$ 30,000 |
||||||||
|
Working Capital Recover |
$ 30,000 |
||||||||
|
Total Cash Inflows (A) |
$ 131,550 |
$ 125,190 |
$ 120,102 |
$ 116,032 |
$ 86,525 |
$ 83,920 |
$ 81,836 |
$ 140,169 |
|
|
Cash Outflows |
|||||||||
|
Cost of Balloons |
-$ 530,000 |
||||||||
|
Working Capital |
-$ 30,000 |
||||||||
|
Total Cash outflows (B) |
-$ 560,000 |
||||||||
|
Total Cash flows (A-B) |
-$ 560,000 |
$ 131,550 |
$ 125,190 |
$ 120,102 |
$ 116,032 |
$ 86,525 |
$ 83,920 |
$ 81,836 |
$ 140,169 |
|
PVF @ 9.66% |
1.0000 |
0.9119 |
0.8316 |
0.7583 |
0.6915 |
0.6306 |
0.5751 |
0.5244 |
0.4782 |
|
Present Value |
-$ 560,000 |
$ 119,962 |
$ 104,105 |
$ 91,076 |
$ 80,239 |
$ 54,563 |
$ 48,259 |
$ 42,915 |
$ 67,029 |
|
Net Present Value |
$ 48,149 |
|
Profitability Index |
1.09 |
|
Internal Rate of Return |
11.87% |
|
Payback Value |
4.41 |
4 years 5 months |
|
|
Discounted Payback Value |
6.74 |
6 years 9 months |
|
Average investment |
$ 530,000 |
|
Average accounting income |
$ 103,166 |
|
Accounting Rate of Return |
19.47% |
Calculation for scenario 2: Large Size balloon
|
Particulars |
Year 0 |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
Year 7 |
Year 8 |
|
Cash Inflows |
|||||||||
|
Operating Sales Revenue (High Demand) |
$ 487,500 |
$ 487,500 |
$ 487,500 |
$ 487,500 |
$ 325,000 |
$ 325,000 |
$ 325,000 |
$ 325,000 |
|
|
Operating Sales Revenue Low Demand) |
$ 75,000 |
$ 75,000 |
$ 75,000 |
$ 75,000 |
$ 150,000 |
$ 150,000 |
$ 150,000 |
$ 150,000 |
|
|
Total Sales |
$ 562,500 |
$ 562,500 |
$ 562,500 |
$ 562,500 |
$ 475,000 |
$ 475,000 |
$ 475,000 |
$ 475,000 |
|
|
Less: |
|||||||||
|
Annual Variable and Fixed cost |
$ 300,000 |
$ 300,000 |
$ 300,000 |
$ 300,000 |
$ 300,000 |
$ 300,000 |
$ 300,000 |
$ 300,000 |
|
|
Warehouse Rent |
$ 50,000 |
$ 50,000 |
$ 50,000 |
$ 50,000 |
$ 50,000 |
$ 50,000 |
$ 50,000 |
$ 50,000 |
|
|
Depreciation |
$ 170,000 |
$ 136,000 |
$ 108,800 |
$ 87,040 |
$ 69,632 |
$ 55,706 |
$ 44,564 |
$ 35,652 |
|
|
Total |
$ 520,000 |
$ 486,000 |
$ 458,800 |
$ 437,040 |
$ 419,632 |
$ 405,706 |
$ 394,564 |
$ 385,652 |
|
|
Profit Before tax after dep |
$ 42,500 |
$ 76,500 |
$ 103,700 |
$ 125,460 |
$ 55,368 |
$ 69,294 |
$ 80,436 |
$ 89,348 |
|
|
Less: Tax |
$ 12,750 |
$ 22,950 |
$ 31,110 |
$ 37,638 |
$ 16,610 |
$ 20,788 |
$ 24,131 |
$ 26,805 |
|
|
Profit after tax after dep |
$ 29,750 |
$ 53,550 |
$ 72,590 |
$ 87,822 |
$ 38,758 |
$ 48,506 |
$ 56,305 |
$ 62,544 |
|
|
Add: Depreciation |
$ 170,000 |
$ 136,000 |
$ 108,800 |
$ 87,040 |
$ 69,632 |
$ 55,706 |
$ 44,564 |
$ 35,652 |
|
|
Profit before dep after tax |
$ 199,750 |
$ 189,550 |
$ 181,390 |
$ 174,862 |
$ 108,390 |
$ 104,212 |
$ 100,869 |
$ 98,195 |
|
|
Salvage of Balloon |
$ 50,000 |
||||||||
|
Working Capital Recover |
$ 50,000 |
||||||||
|
Total Cash Inflows (A) |
$ 199,750 |
$ 189,550 |
$ 181,390 |
$ 174,862 |
$ 108,390 |
$ 104,212 |
$ 100,869 |
$ 198,195 |
|
|
Cash Outflows |
|||||||||
|
Cost of Balloons |
-$ 850,000 |
||||||||
|
Working Capital |
-$ 50,000 |
||||||||
|
Total Cash outflows (B) |
-$ 900,000 |
||||||||
|
Total Cash flows (A-B) |
-$ 900,000 |
$ 199,750 |
$ 189,550 |
$ 181,390 |
$ 174,862 |
$ 108,390 |
$ 104,212 |
$ 100,869 |
$ 198,195 |
|
PVF @ 9.66% |
1.000 |
0.912 |
0.832 |
0.758 |
0.692 |
0.631 |
0.575 |
0.524 |
0.478 |
|
Present Value |
-$ 900,000 |
$ 182,154 |
$ 157,626 |
$ 137,553 |
$ 120,921 |
$ 68,351 |
$ 59,928 |
$ 52,896 |
$ 94,778 |
|
Net Present Value |
-$ 25,794 |
|
Profitability Index |
0.97 |
|
Internal Rate of Return |
8.87% |
|
Payback Value |
4.962 |
4 years 11 months |
|
Discounted Payback Value |
7.74 |
or 7 years 9 months |
|
Average investment |
$ 850,000 |
|
Average accounting income |
$ 144,652 |
|
Accounting Rate of Return |
17.02% |
As in this case business is unprofitable we should look after the case when the large balloon is sold at year 4
|
Net Present Value |
$ 9,439 |
|
Profitability Index |
1.01 |
|
Internal Rate of Return |
10.02% |
|
Payback Value |
3.45 |
3years 6 months |
|
|
Discounted Payback Value |
3.86 |
3 years 11 months |
|
Average investment |
$ 850,000 |
|
Average accounting income |
$ 298,888 |
|
Accounting Rate of Return |
35.16% |
The application of capital budgeting has been performed on the given two scenarios and results has been noted. The methods used to make analyze are NPV, IRR, ARR, Payback, Profitability Index, and Discounted payback. In scenario the NPV is positive $48149 in case of small balloon as compare to NPV of negative -$25794 in case of large balloon. So it is decided to calculation for 4 years than it has been found that NPV of large balloon is positive $9439. So it is recommended to the management to invest in small balloon due to maximum NPV and IRR (Brealey, 2012).
Conclusion
Thus, it can be stated from the overall discussion held in the report that project manager need to analyze the feasibility of project option though the use of appropriate capital budgeting techniques. This is essential to minimize the risk associated with the failure of the project option that incurs large investment. As such, the feasibility of the project option of replacement of current balloon by with both hot and small balloon is analyzed through the use of capital budgeting techniques by Branson Ltd.
References
Besley, S. and Brigham, E. F. 2008. Essentials of Managerial Finance. Cengage Learning.
Bierman, H. 2012. The Capital Structure Decision. Springer Science & Business Media.
Bierman, H. and Smidt, S. 2007. The Capital Budgeting Decision: Economic Analysis of Investment Projects. Routledge.
Brealey, R. 2012. Principles of Corporate Finance. Tata McGraw-Hill Education.
Bromwich, M. and Bhimani, A., 2005. Management accounting: Pathways to progress. Cima publishing.
Peterson, P,P and Fabozzi,F, J,. 2002. Capital budgeting: theory and practice. John Wiley & sons.
Higgins, R. C., 2012. Analysis for financial management. McGraw-Hill/Irwin.
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