A project namely as Bisham came up by Virgin Media Inc - Essay Example

?Virgin Media Inc. – Project Bisham Introduction Virgin Media Inc. is come up with a project ly as Bisham which has a total life of eight years. This article aims to evaluate on financial grounds whether the project is worthwhile for the company or not. At the same time, issues including use of net incremental cash flows, impact of tax rate changes, credit rating downgrade and the appropriateness of the discount rate are also highlighted and discussed in this article. Appendices are also attached which represent the computation of Net Present Value, Weighted Average Cost of Capital and Internal Rate of Return for the project Bisham. Incremental Cash Flow Approach and its Appropriateness Investment appraisal techniques basically work on the basis of incremental cash flows and not on the basis of net income. Incremental cash flows are the additional cash flows that a firm generates by investing in a particular project, thus the cash flows being generated from that project are added to the projected net income of the firm. However, in order to ensure whether a certain project is viable for the firm or not, the decision lies on the overall net cash flows pertaining to that project. The net cash flows of a particular project can be obtained by subtracting the net income of the company without accepting a project, from the net income of the firm with accepting a project. The basic formula for the incremental cash flows of a particular project is: Net cash flows of the project = Net Income of the company with the project - Net Income of the company without the project The reason behind using incremental cash flow approach in investment appraisal techniques is that it clearly states the actual cash outflows and inflows of a particular project. In case, when a firm has more than one projects and the firm has to decide which project needs to be opted, at that time this incremental approach assists the financial managers of the company, as the overall net income of the company might increase with every project, but the incremental cash flow approach clearly distinct between every project and their viability. As a result, the incremental approach is more useful in appraising different projects. Difficulties in Estimation of Incremental Cash Flows Incremental Cash flow approach has various difficulties in estimating the forecasted cash flows pertaining to a particular project. These difficulties are as follows: Future projection of cash flows is subject to judgment of the financial analysts which vary with person to person. Inflation rate is subject to unpredictability as local economy as well as global economy may perform either way. The decision of operating cash flows are subject to pure judgment as nobody knows about the cost of direct material, future wage rates and above all the factory overheads estimates during the project life. The tax rate may change due to change in government’s policy. The working capital requirements are subject to pure judgments as to how to estimate them and the assumption regarding their reversal in the last year of the project. Net Cash Flows of Project Bisham under current conditions The following are the net cash flows of the project Bisham for 8 years project life. Yrs 0 1 2 3 4 5 6 7 8 NCF (1,400,000) 199,700 334,000 317,125 304,469 294,977 287,857 282,518 398,514 In the above table, year 0 indicates the year in which the initial investment is made in the project in the form of purchasing of two machineries naming as Machinery A and B for $1,200,000 and $200,000 respectively. The other figures included in the net cash flows from year 1 to year 8 are derived in such a manner that operating cash flows are computed first. Cost per unit of the product is first calculated by adding up per unit cost of each material, labor and factory overhead. Then these variable costs are deducted from the selling price per unit to obtain the contribution per unit. Contribution per unit for each year is then multiplied by the total number of units to be produced and sold each year to obtain total contribution. Amounts of depreciation for both the machineries are computed such that depreciation for machinery A is computed on the basis of 25% reducing balance method and the depreciation for machinery B is computed on straight line basis for 8 years. The amounts of depreciation are then deducted from the contribution to arrive at the profit before tax. With the tax rate of 30%, the tax payments are calculated and then deducted from the profit before tax figure. In this way profit after tax figure is computed. Being a non-cash expense, the depreciation amounts are then added back to the profit after tax figure to arrive at the net incremental cash flow figures which are also mentioned in the above table as well. Bisham Project Appraisal Decision In order to evaluate whether Virgin Media Inc. go ahead for the project Bisham or not, the company has to calculate the Net Present Value of the incremental cash flows of the project. For discount, weighted average cost of capital is computed first such that cost of equity and after-tax cost of debt are averaged out on the basis of the weights in proportion to its capital structure of the company. Under current condition, the credit rating of the company is AA therefore, 4.96% is taken as the company’s cost of debt. The weighted average cost of capital with the tax rate of 30% is computed as 3.98%. The discount factor is then computed and then multiplied by the net incremental cash flows to obtain the discounted cash flow figures. These discounted cash flow figures are then added up to arrive at the Net Present Value of the project which is positive $620,585. Since the computed Net Present Value is positive therefore, on financial grounds, Virgin Media Inc. is advised to accept this project as this project would remain beneficial for the company. Effect of Increase in Tax Rate The increase in the proposed change in the tax rate from 30% to 35% would have two impacts on overall basis. The first impact would be on the incremental net cash flows of the project such that the tax payments for every year would be increased causing the incremental net cash flows to decrease. The second impact of the proposed tax rate change would be on weighted average cost of capital of the company such that it would be reduced due to the after-tax effect as interest payments on the debts are tax deductable. Both these effects would have the opposing effect but they cannot exactly cancel out each other as the impact of increase in the tax payments is more than the impact of decrease in weighted average cost of capital. Recommendation for the Bisham Project Appraisal with the effect of increase in Tax Rate The recommendation for Bisham project would not be changed as a result of proposed tax rate changes because the Net Present Value of the Bisham project is still quite better for the Virgin Media Inc. There is a loss of around $45,000 in the Net Present Value because of the proposed change, but still the Net Present Value of $575,799 is a positive figure which suggests that the project Bisham is still worthwhile for Virgin Media Inc. to accept. Impact of Credit Rating Downgrade The possible credit rating downgrade shows the riskiness of the company as the company becomes more risky than it was ever before. Due to become more risky, the investors hesitate in investing the securities of that company and demand for more return. In case of debt, the investors demand higher coupon rates from the company which in turn increases the cost of debt of the company. Thus, if a company’s credit rating is downgraded, it suffers an increase in the cost of debt which causes overall weighted average cost of capital to increase. In this scenario, Virgin Media Inc. currently has the credit rating of “AA” and it can raise debt finance on 4.96% as its cost of debt. By keeping this cost of debt in the formula, the weighted average cost of capital is found to be 3.98% with keeping in view the effective tax rate of 30%. However, if the company faces credit rating downgrade and the assigned credit rating falls to “A” then the company’s cost of debt would be increased to 5.03%. This increase in the cost of debt would as a result increase the cost of capital of Virgin Media Inc. and the new weighted average cost of capital would be 4.01% having the effect of tax rate of 30%. However, if the tax rate is increased to 35%, then the weighted average cost of capital of the company would fall to 3.86%. Recommendation for the Bisham Project Appraisal with the effect of increase in Tax Rate as well as with the impact of Credit Rating Downgrade In case if both the proposed change in the rate from 30% to 35% occurs and the credit rating slips from AA to A, the project Bisham would still remain feasible for Virgin Media Inc. and cab be accepted as it would yield in positive Net Present Value of $573,247. Relationship between WACC and Discount Rate Weighted Average Cost of Capital is the rate of return that the investors require from the company. A company must estimate its weighted average cost of capital in order to decide as what should be the future distributions to the investors in various forms including dividend, interest etc. Discount rate is the rate which is used to discount the future net cash flows to today. Weighted average cost of capital is used as a discount rate due to the fact that it is the rate which has to be offered to the investors if the project in question is accepted. The net present value of the project computed on the basis of weighted average cost of capital as a discount rate would provide a meaningful picture to the company and the company would be able to evaluate the overall project specifications in a better manner. The use of the discount rate determines its appropriateness. For instance, in case of simply valuing the benefits to be achieved from a particular project, weighted average of cost of capital would be suitable. However, if the intent is to evaluate the better choice between the alternative investment opportunities relating to different projects, reinvestment rate can be used as a discount rate. Internal Rate of Return for Project Bisham The maximum discount rate that the project Bisham can afford is the Internal Rate of Return (IRR). IRR is the rate that makes the Net Present Value of the project equals to zero. For project Bisham, the IRR is computed as 8.92% with the effective tax rate of 30%. References Baker, H. Kent . and Martin, Gerald S., 2011.Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. New York: John Wiley & Sons. Berk, Jonathan B. and DeMarzo. Peter M., 2010. Corporate finance. 2nd ed. New York: Prentice Hall. Bierman, Harold., 2003. The capital structure decision. New York: Springer. Boehme, Rodney. Valuation and Capital Budgeting for the Levered Firm. Available through < Brigham, Eugene F. and Ehrhardt, Michael C., 2008. Financial management: theory and practice. 12th ed. New York: Cengage Learning. Eckbo, Bjorn Espen., 2008. Handbook of corporate finance: empirical corporate finance. Oxford: Elsevier. Jaffe, Jeffrey. and Ross, Randolph Westerfield., 2004. Corporate Finance. New Delhi: Tata McGraw-Hill Education. Khan, M. Y., 2004. Financial Management: Text, Problems And Cases. 2nd ed. New Delhi: Tata McGraw-Hill Education. Shim, Jae K. and Siegel, Joel G., 2008. Financial Management. 3rd ed. Oxford: Barron's Educational Series. Vishwanath, S. R., 2007. Corporate Finance: Theory and Practice. 2nd ed. California: SAGE. Watson, Denzil. and Head, Antony., 2009, Corporate Finance Book and MyFinancelab Xl. 5th ed. New York: Pearson Education, Limited. Appendix Years 0 1 2 3 4 5 6 7 8 Machinery A (1,200,000)   Machinery B (200,000)   Units 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 SP 360 360 360 360 360 360 360 360 Variable Cost   Material A 48 48 48 48 48 48 48 48 Material B 19 20 20 20 20 20 20 20 Material C 8 22 22 22 22 22 22 22 Labour 192 132 132 132 132 132 132 132 FOH 64 64 64 64 64 64 64 64 Total VC 331 286 286 286 286 286 286 286 Contribution 29 74 74 74 74 74 74 74 Total Contribution 146,000 370,000 370,000 370,000 370,000 370,000 370,000 370,000 Depreciation A (300,000) (225,000) (168,750) (126,563) (94,922) (71,191) (53,394) (40,045) Depreciation B (25,000) (25,000) (25,000) (25,000) (25,000) (25,000) (25,000) (25,000)     Current Condition   PBT (179,000) 120,000 176,250 218,438 250,078 273,809 291,606 304,955 Tax (30%) 53,700 (36,000) (52,875) (65,531) (75,023) (82,143) (87,482) (91,486) PAT (125,300) 84,000 123,375 152,906 175,055 191,666 204,125 213,468 Realizable Value - - - - - - - 120,000 Depreciation A 300,000 225,000 168,750 126,563 94,922 71,191 53,394 40,045 Depreciation B   25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 Net Cash Flow (1,400,000) 199,700 334,000 317,125 304,469 294,977 287,857 282,518 398,514 WACC (3.98%) 1.0000 0.9617 0.9249 0.8895 0.8555 0.8227 0.7912 0.7609 0.7318 Discounted Cash Flows (1,400,000) 192,056 308,921 282,086 260,461 242,682 227,761 214,980 291,638 NPV 620,585                 Tax Rate Increase                   PBT (179,000) 120,000 176,250 218,438 250,078 273,809 291,606 304,955 Tax (35%) 62,650 (42,000) (61,688) (76,453) (87,527) (95,833) (102,062) (106,734) PAT (116,350) 78,000 114,563 141,984 162,551 177,976 189,544 198,221 Realizable Value - - - - - - - 120,000 Depreciation A 300,000 225,000 168,750 126,563 94,922 71,191 53,394 40,045 Depreciation B 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 Net Cash Flow (1,400,000) 208,650 328,000 308,313 293,547 282,473 274,167 267,938 383,266 WACC (3.83%) 1.0000 0.9631 0.9276 0.8934 0.8604 0.8287 0.7981 0.7687 0.7403 Discounted Cash Flows (1,400,000) 200,953 304,248 275,437 252,572 234,079 218,815 205,956 283,738 NPV 575,799                 Adverse Condition & Tax Rate Increase               PBT (179,000) 120,000 176,250 218,438 250,078 273,809 291,606 304,955 Tax (35%) 62,650 (42,000) (61,688) (76,453) (87,527) (95,833) (102,062) (106,734) PAT (116,350) 78,000 114,563 141,984 162,551 177,976 189,544 198,221 Realizable Value - - - - - - - 120,000 Depreciation A 300,000 225,000 168,750 126,563 94,922 71,191 53,394 40,045 Depreciation B 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 Net Cash Flow (1,400,000) 208,650 328,000 308,313 293,547 282,473 274,167 267,938 383,266 WACC (3.86%) 1.0000 0.9628 0.9271 0.8926 0.8594 0.8275 0.7967 0.7671 0.7386 Discounted Cash Flows (1,400,000) 200,895 304,073 275,199 252,281 233,741 218,437 205,540 283,083 NPV 573,247                 Weighted Average Cost of Capital   Debt 60% Rf 0.10% Equity 40% Beta 1.6 At tax rate 30%   Market Return 3.00% WACC - if rating is AA 3.98% Cost of Equity 4.74% WACC - if rating is A 4.01%   At tax rate 35%   Cost of Debt -20yr AA 4.96% WACC - if rating is AA 3.83% Cost of Debt -20yr A 5.03%   WACC - if rating is A 3.86% Years 0 1 2 3 4 5 6 7 8 NCF (1,400,000) 192,056 308,921 282,086 260,461 242,682 227,761 214,980 291,638 IRR 8.92%                 Read More