Principles of Finance - Essay Example

 Introduction 3 Analysis and Discussion 3 Cost Analysis 3 Analysis of Cash Flow 5 Investment Evaluation 7 Payback Period 7 Net Present Value 7 Internal Rate of Return 8 Index of Profitability 9 Acceptance or rejection 9 Rejection 10 Acceptance 11 Conclusion 11 References 13 Introduction In this part of the study, we would compare the specialized equipment and packaging facilities from Donnalley Limited as well as Danforth Limited in context of the expenses or costs involved. For this comparison, it would be implicit that the equipments will be substituted at the completion of its economic life and that both companies would be capable of supplying the equipments on the similar terms for an indefinite period. Analysis and Discussion Cost Analysis The evaluation of the purchase of the equipment and packaging facilities for the Dynamo project should be made on the basis of cost-benefit examination to prepare most favorable progress plans. Cost refers to the worth of assets utilized in the implementation of the equipment, starting from transportation, installation and maintenance. The total cost of a project consists of cost of capital, assets, labor expenses, intermediate resources, staff salaries and production expenses among others. Costs can be in different forms, such as real, nominal, primary, secondary, associated expenses and project expenses among others (Horngren, 2008). Hence, while appraising the equipment and facilities manufactured by Danforth Limited and Donnalley Limited, one would have to compute as well as compare the costs involved in both of them. The product of the company that involves relatively less expenses should be chosen over the other. Expenses related to the equipment manufactured by Dansforth Limited: Purchase Cost $1,200,000 Shipping fees $10,000 Installation fees $20,000 Total Expenses $1,230,000 Salvage value after 5 years $50,000 The annual cost savings on operating and maintaining costs using the equipment facility of Dansforth Limited is equivalent to $20,000. This equipment and packaging facility is likely to reduce the initial project outlay and cost of debt from $1.5 million to $0.7 million. Expenses related to the equipment manufactured by Donnalley Limited On the other hand, the purchase cost of the equipment and packaging facility from Donnalley Limited is equal to $2 million. Additionally it has been ascertained that the estimated salvage value of the facility after 10 years would be equivalent to $80,000, which is much higher than that of Dansforth Limited’s equipment. Furthermore, the economic life of Danforth Limited’s equipment facility is only 5 years while that of Donnalley Limited is 10 years. This implies that during the 10 years time frame, the total cost involved with the purchase of equipment from Danforth Limited would be doubled. Consequently, the total costs over the project life of 10 years for Danforth Limited would be more than that of Donnalley Limited by $2 million. Hence it would be advisable for Radiant Laundry Products Company to purchase the specialised equipment and packaging facilities from Donnalley Limited. Analysis of Cash Flow Capital budgeting choices are supposed to be based on cash flows, instead of accounting profits. Additionally it is the incremental cash flows that are applicable (Broyles, 2003; Polimeni & Et. Al., 1994). Thus, we would compute the additional cash flow that Radiant Limited expects to generate if it implements the Dynamo project. The components for the computation of cash flow for the Dynamo Project are as follows: Investment for test marketing = $1,500,000 Cost of Equipment= $2,000,000 Total Initial Investment = $3,500,000, Cost of funds: 15% Salvage value = $80,000 Economic life= 10 Depreciation per year (at the rate of 30% on the reducing balance basis) Year Rate Value of Equipment Depreciation 1 30% 2000000 600000 2 1400000 420000 3 980000 294000 4 686000 205800 5 480200 144060 6 336140 100842 7 235298 70589.4 8 164708.6 49412.6 9 115296.0 34588.8 10 80707.2 24212.2 Annual Rent = $120,000 Annual Interest = 12% of $1500000 = $180,000 Annual operation Cash Flows: Year Increased cash flow from the Dynamo project Lost sales from existing product lines Incremental cash flow Annual Rent Depreciation Net Cash flow 0 -$3500000 1 $580,000 $70,000 $490,000 $120,000 $600000 -$230000 2 $580,000 $70,000 $490,000 $120,000 $420000 -$50000 3 $580,000 $70,000 $490,000 $120,000 $294000 $76000 4 $580,000 $580,000 $490,000 $120,000 $205800 $164200 5 $650,000 $110,000 $540,000 $120,000 $144060 $275940 6 $650,000 $110,000 $540,000 $120,000 $100842 $319158 7 $650,000 $110,000 $540,000 $120,000 $70589.4 $349410.6 8 $550,000 $100,000 $450,000 $120,000 $49412.6 $280587.4 9 $550,000 $100,000 $450,000 $120,000 $34588.8 $295411.2 10 $550,000 $100,000 $450,000 $120,000 $24212.2 $305787.7+ $80,000 = $385787.7 Investment Evaluation Payback Period The payback period of a project would be equivalent to the number of years in which the project would be able to recoup the initial outlay made in it. Payback Period (PB) = Years before cost recovery + (Remaining cost to recover/ Cash inflow during the year) (Mole & Et. Al., 2011) If we look at the net cash inflows expected from the Dynamo project, it can be inferred that the payback period for this project would be more than 10 years, as the project is unlikely to recoup the initial investment in the coming 10 years. Net Present Value The net present value of the cash flows generated from the project can be computed as follows: , where k= cost of capital. (Mole & Et. Al., 2011) Thus, discounting the cash flows at the rate of 15%, the NPV for the Dynamo Project is as follows, NPV = -3500000+ (-230000)/ (1.15)1 + (-50000)/ (1.15)2 + 76000/ (1.15)3 + 164200/ (1.15)4 + 275940/ (1.15)5 + 319158/ (1.15)6 + 349410.6/ (1.15)7 + 280587.4/ (1.15)8 + 295411.2/ (1.15)9 + 385787.7/ (1.15)10 NPV = -$2,916,366.28 Internal Rate of Return The internal rate of return is the discount rate, at which the NPV of the cash flows generated by the project would be zero. The equation for the internal rate of return for a project can be represented as follows, Accordingly, the IRR for Machine ‘A’ can be computed as, NPV = -3500000+ (-230000)/ (1 + IRR) 1 + (-50000)/ (1 + IRR) 2 + 76000/ (1 + IRR) 3 + 164200/ (1 + IRR) 4 + 275940/ (1 + IRR) 5 + 319158/ (1 + IRR) 6 + 349410.6/ (1 + IRR) 7 + 280587.4/ (1 + IRR) 8 + 295411.2/ (1 + IRR) 9+ 385787.7/ (1 + IRR) 10 = 0 Thus, IRR of the Dynamo project comes out to be 5%. Index of Profitability The index of profitability or the benefit-cost ratio is computed as follows, Index of profitability (IP) = PV of cash inflow/ Initial investment. (Siddiqui, 2006). The present value of the cash inflows from Project can be represented as, PVA = (-230000)/ (1.15)1 + (-50000)/ (1.15)2 + 76000/ (1.15)3 + 164200/ (1.15)4 + 275940/ (1.15)5 + 319158/ (1.15)6 + 349410.6/ (1.15)7 + 280587.4/ (1.15)8 + 295411.2/ (1.15)9 + 385787.7/ (1.15)10 = $583,633.72 IPA = $583,633.72 / $3500000= 0.17 Hence, it can be conclusively stated that the Dynamo project cannot be accepted as the net present value of the project is negative and the payback period of the same is more than 10 years. Acceptance or rejection The initial investment in the project is too huge, and even if we ignore the initial test marketing expenses involved, the net present value of the Dynamo project is less than zero. The project would be set in the premises of Radiant Laundry Products Company and the company does not have the policy of charging rent for its projects. In view of this exclusion in addition to ignoring the test marketing cost already incurred in the previous year, the net present value of the Dynamo Project if discounted at the rate of 15% come out to be -$814,114.05. Thus, it would not be advisable to take up this project. If the scenario is such that the rejection of Dynamo project by Radiant Laundry would lead to the introduction of an identical product by a direct rival, then Radiant Laundry should take a decision on it on the basis of a time period more than 10 years. This is because this project is not viable when considered for a period of around 10 years. Moreover, another imperative point to be considered by Radiant Laundry is the redundant effect the rival’s product would have on its sales figure. If the introduction of a similar product by a direct rival dose not hampers the sales of Radiant to a large extent, then the company should avoid taking up the Dynamo project. Rejection The following segment of the paper focuses on the sensitivity analysis of the project’s NPV on to annual net cash flows and cost of capital individually. For the analysis, the net cash flows were increased by 20% while the cost of capital was decreased by 20%. Cash Flows Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5 0 -3500000 -3500000 -3500000 -3500000 -3500000 -3500000 1 -230000 -184000 -147200 -117760 117760 141312 2 -50000 -40000 -32000 -25600 -20480 -16384 3 76000 91200 109440 131328 157593.6 189112.32 4 164200 197040 236448 283737.6 340485.12 408582.144 5 275940 331128 397353.6 476824.32 572189.184 686627.0208 6 319158 382989.6 459587.52 551505.024 661806.0288 794167.2346 7 349410.6 419292.72 503151.264 603781.5168 724537.8202 869445.3842 8 280587.4 336704.88 404045.856 484855.0272 581826.0326 698191.2392 9 295411.2 354493.44 425392.128 510470.5536 612564.6643 735077.5972 10 385787.7 462945.24 555534.288 666641.1456 799969.3747 959963.2497 Rate 15% 12% 10% 8% 6% 5% NPV ($2,916,366.28) ($2,521,565.21) ($2,030,052.87) ($1,423,757.14) ($482,522.94) $424,904.17 It can be seen from the above calculations that the NPV of the Dynamo project is positive only in the 5th scenario where the cost of capital has been assumed to be 5%. Acceptance The process of investment appraisal helps the firm’s management to make a decision on which investment or project they should undertake. While making these decisions, the aim of the management is to opt for projects that would augment the firm’s value. . Investments enhance the company’s value when they generate more return than their cost of capital. Since capital investments entail considerable amount of cash outflows that cannot be easily recouped, hence investment appraisal decisions are considered to be the most significant management decisions. The popularly used techniques to appraise capital investment decisions are the payback method, accounting rate of return, index of profitability, net present value (NPV) and the internal rate of return (IRR). The pay back and the accounting rate of return methods do not consider the time value of money and have some severe shortcomings. The net present value emphasizes on time value of money and also makes available a measure of how much an investment would add to the company’s worth. The internal rate of return is actually the expected rate of return for a capital investment. Akin to the NPV, the IRR method entails discounting the expected cash flows from an investment (Atrill & McLaney, 1994). Conclusion The assessment of the Dynamo Project using the NPV, IRR, payback and the profitability index reveals that it would not be advisable to take up this project unless the life of the project is more than 10 years. This is because the project is expected to generate relatively more cash inflows in the subsequent years as compared to the preliminary years. References Atrill, P., & McLaney, E., (1994). Management Accounting: An Active Learning Approach. Wiley- Blackwell. Broyles, J. E., (2003). Financial Management and Real Options. John Wiley & Sons. Horngren, C., (2008). Introduction to Management Accounting. Pearson Education. Moles, P., & Et. Al., (2011). Fundamentals of Corporate Finance. John Wiley and Sons. Polimeni, R. S., & Et. Al., (1994). Schaum's Outline of Theory and Problems of Cost Accounting. McGraw-Hill Professional. Siddiqui, S. A., (2006). Managerial Economics and Financial Analysis. New Age International. Read More