Principles of Finance and Capital Budgeting - Essay Example

Capital Budgeting Working Computers Net Cash Flow Per Year- Table 03 04 05 06 07 08 09 Annual sales74,250,000 93,555,000 121,770,000 130,680,000 130,680,000 130,680,000 Cogs 44,550,000 56,133,000 73,062,000 78,408,000 78,408,000 78,408,000 Expenses 17,820,000 22,453,200 29,224,800 31,363,200 31,363,200 31,363,200 Depreciation 3,920,000 3,920,000 3,920,000 3,920,000 3,360,000 1,680,000 Income before taxes 7,960,000 11,048,800 15,563,200 16,988,800 17,548,800 19,228,800 Income tax at marginal rate (34%) 2,706,400 3,756,592 5,291,488 5,776,192 5,966,592 6,537,792 Net income 5,253,600 7,292,208 10,271,712 11,212,608 11,582,208 12,691,008 Net annual cash flow 9,173,600 11,212,208 14,191,712 15,132,608 14,942,208 14,371,008 Working Computers Net cash flow Table 2 03 04 05 06 07 08 09 Annual sales 74,250,000 50,490,000 28,215,000 23,760,000 23,760,000 23,760,000 Cogs 40,095,000 27,264,600 15,236,100 12,830,400 12,830,400 12,830,400 Expenses 19,305,000 13,127,400 7,335,900 6,177,600 6,177,600 6,177,600 Depreciation 3,920,000 3,920,000 3,920,000 3,920,000 3,360,000 1,680,000 Income before tax 10,930,000 6,178,000 1,723,000 832,000 1,392,000 3,072,000 Tax 3,716,200 2,100,520 585,820 282,880 473,280 1,044,480 Net income 7,213,800 4,077,480 1,137,180 549,120 918,720 2,027,520 Net annual cash flow 11,133,800 7,997,480 5,057,180 4,469.120 4,278,720 3,707,520 a) Increase in accounts receivables and accounts payable increase or decrease net revenues, respectively. Increase or decrease in inventories also increases or decreases the net revenues. Any item that increases or decreases the net revenues should be included in the cash flow table to determine the net cash flow for that year. b) The $18 million loan should not be included in the cash flow table because it refers to an out flow in the previous year. It can only be used during the calculation of the Net Present Value since it contributes to the initial investment amount. However, the yearly interest expense should be included in the cash flow table since it contributes to the net expenses which reduce the net income amount. c) The depreciation allowance should be included in the cash flow table since depreciation occurs yearly or continuously. The only difference is the rate of depreciation per year which should be taken into consideration. The $18,000,000 new investment, is only included in the cash flow table if the investment took place within the years whose cash flows were being determined, however, it should only be included in the very year it occurred. In deriving the cash flow figures, the following assumptions were considered: i) The depreciation amount differs according to the year concerned. ii) The depreciation amount should be added back to the net income to find the net cash flow per year 2. a) Payback period Net Cash flow Time for cash flow to payback investment Initial investment 18,000,000 04 9,173,600 9,173,600 05 11,212,208 20,385,808 06 14,192,712 34,578,520 07 15,132,608 49,711,128 08 14,942,208 64,653,336 09 14,371,008 79,024,344 I would therefore recommend the board of working computers, under payback period, to invest the $18,000,000 in Bernoulli since the initial investment will be paid back only during the second year of operation where the net cash flow will be $20,385,808. b) Net Present Value Cash flows 14.5% PV factors Present Value 03 04 9,173,600 0.8734 8,012,222 05 11,212,208 0.7628 8,552,672 06 14,192,712 0.6662 9,455,185 07 15,132,608 0.5818 8,804,151 08 14,942,208 0.5081 7,592,136 09 14,371,008 0.4438 6,377,853 Total 48,794,219 Investment 18,000,000 NPV 30,794,219 Following the NPV calculations above, the NPV is $30,794,219/ the general criterion for NPV is that, a project is accepted if it has a positive NPV. A higher NPV is even more preferred. In this case, if working computers invest $18,000,000 in Bernoulli, the NPV is positive hence I would advise them to invest in the project. c) IRR Investment -18,000,000 04 9,713,600 05 11,212,208 06 14,192,712 07 15,132,608 08 14,942,208 09 14,371,008 IRR 66.98% The IRR is calculated by entering the figures above into the excel function. The general criterion on IRR is that, the project is accepted if the IRR is greater than the cost of capital. The cost of capital here is 14.5% and IRR is 66.98%. Therefore, I can recommend that the working computers should invest on the Bernoulli since the IRR is greater than the cost of capital. 3) a) Sensitivity analysis of NPV Assumption: WACC is 3% higher which is 14.5 + 3= 17.5% New unit sales = 20% less New NPV would be Cash flow NPV Factor 17.5% Present value 04 7,770,880 0.8510 6,613,019 05 8,969,766 0.7243 6,496,802 06 11,354,170 0.6164 6,998,710 07 12,106,086 0.5246 6,350,852 08 11,953,664 0.4464 5,336,116 09 11,496,806 0.3799 4,367,637 Total 36,163,136 Investment 18,000,000 NPV 18,163,136 The new NPV would be $18,163,136 Percentage change in NPV = (18,163,136 x 30,794,219) / 30,794,219 = -41.01% Percentage change in Cost of Capital = (17.5 – 14.5) / 14.5% = 20.7% Therefore, the percentage change in NPV per 1% change in Cost of capital is -1.98 b) If the discount rate is at 20% on the unit price, the new price would be 495 x 0.8 = $396 Therefore, the net cash flow would decrease by 20%. This would mean that the resulting NPV also reduces by 20%, hence the new NPV would be: 0.8 x 18,163,136 = $14,530,509 c) The minimum annual sales of the Bernoulli before elimination: The unit of product is (264,000 + 264,000+ 264,000 + 246,000 + 189,000 + 150,000 + 180,000) x 495 = $509,356,485 4) Recommendation To Working Computers on contributing $18,000,000 to Bernoulli division Working computers would use the sensitivity index to make a proper decision on whether to contribute $18,000,000 to the Bernoulli division. A part from the sensitivity calculated above, the Company can also use NPV, IRR and the payback period methods to make an informed decision on whether to contribute to the Bernoulli Division, $18,000,000 for the project. To begin with, a negative sensitivity always means that, the output (Net present Value) decreases with an increase in the cost of capital (input). According to the sensitivity calculated above, therefore, items like discount rates on the sales unit price would reduce the net present value of the project. Therefore, with discount given, the working computers would not be so much making a good decision by contributing the $18,000,000 to the Bernoulli Division. The net present value is most sensitive to the changes in the cost of capital; hence, this should first be studied before the company makes the decision. Again, the NPV is positive, hence encouraging the company to continue with its investment plans on Bernoulli, the IRR is higher than the cost of capital as required and the Payback period is just in the second year of investment, hence, it is most appropriate for the company to contribute to the Bernoulli Division. 5) If Working Computers would want to sell Bernoulli today, considering the sales projections on exhibit 1, the company would have to determine the net worth of Bernoulli through the use of the sales projections as presented in Exhibit 1. To do this, the company would have to consider the sales of the last year, the salvage value, working capital, and the total depreciation on the investment assets so far. To do this, the net present value would need to be calculated; but to calculate the present value for the last year, the salvage value, working capital and the depreciation will need to be considered. We can also determine the price by calculating the value of the company at last investment/ this would be: 264,000 x 495 = $130,680,000 The investment of $18,000,000 then will be added to bring $148,680,000 Therefore, the selling price would be $148,000,000. In case we were given the salvage value and working capital, we could have added the salvage value to the amount plus the working capital 6) When a firm is considering to eliminate a product or to sell a division, it would have to consider the asset value of the firm, the investment in the firm, the profitability of the product or the division, the net present value of the firm, its average rate of return, the payback period of the investment and the human and asset resources that have been employed in the firm. If it is a product and it does not bring any positive cash flows, then it should be sold or eliminated. The management can also ratios such as the profitability ratios, leverage ratios, inventory, return on investment ratios, investment ratios to make decision on whether the product or a division is worth keeping or whether it should be eliminated to allow the growth of other products or divisions by using the capital to improve investment level in that particular area of investment. In conclusion, a company is supposed to be vigilant about the projects that it invests in so as to avoid making decisions that would make the management regret or lose its cash flows. There are various measures of evaluating the profitability for the viability of projects through the use of capital budgeting that would help a company to take the best decision on what to invest on. Calculating the net present value, payback period, internal rate of return, average rate of return, sensitivity and other financial ratios are some of the ways to determine the best project by evaluating the projects profitability. Read More