Cash Flow Estimation and Risk Analysis of Capital Budgeting - Assignment Example

?The following report presents the investment appraisal of new expansion plan of the company Target. For the purpose of initial evaluation, the NPV and IRR technique has been utilized. Investment appraisal through NPV method and IRR method are both very useful in order to financially attractive prospective of any investment decision. A good financial analysis is based on the tradeoff between these two methods. However, practically the IRR method is used widely in investment appraisal decision. The prime reason behind selecting the IRR method of appraisal is it is comparatively straight forward and can be used without having a prior experience in capital budgeting. NPV method has certain drawbacks and limitations. Different projects must be assessed at different discount rates because the risk for each project is generally different. The reliability of the NPV based investment appraisal can be as reliable as the discount rate itself. However, in practice, it is very unrealistic to determine different discount rate for different investment proposals. Whereas, IRR uses a single discount rate to evaluate every investment, due to which it is used extensively among the financial analysts. Following is the mathematical computation of the NPV, IRR and MIRR of the proposed investment Particulars Year Now 1 2 3 4 Sales - 250,000 257,500 265,225 273,182 Cost of sales - (125,000) (128,750) (132,613) (136,591) Depreciation Charges - (79,200) (108,000) (36,000) (16,800) Profit before tax - 45,801 20,752 96,616 119,795 Taxation - (18,320) (8,301) (38,646) (47,918) Profit after tax - 27,481 12,451 57,969 71,877 Depreciation Charges (added back) - 79,200 108,000 36,000 16,800 Rent forgone - (20,000) (20,000) (20,000) (20,000) Working Capital (30,000) (900) (927) (955) 32,782 Sale proceed from disposal of asset - - - - 25,000 Capital expenditure Invoice amount (200,000) - - - - Shipping charges (10,000) - - - - Installation charges (30,000) - - - - Net Cash flow (270,000) 85,781 99,524 73,014 126,459 Present value factor 1 0.9091 0.8264 0.7513 0.6830 Present Value (270,000) 77,982 82,251 54,857 86,373 Net present value 31,464 IRR 15% MIRR 13% As apparent from the above initial investment appraisal analysis, the project appears to be lucrative and feasible as the Net present value is positive and the Internal rate of return and the marginal rate of return is both higher than the cost of capital of the company. It is also of prime importance to perform a sensitivity analysis on any investment appraisal in order to analyze how sensitive is the profitability of the project is to the variables of the project. Sensitivity Analysis Unit Sales Variation Plus 10% Minus 10% NPV 106,379 7,266 Salvage Value Variation Plus 20% Minus 20% NPV 60,238 20,000 Cost of capital Variation Plus 30% Minus 30% NPV (91,978) 593,097 Following is the graphical representation of the sensitivity analysis Change in unit sales Change in sale proceeds on disposal Change in discount rate As apparent from the above analysis, the project is not so much sensitive to the change in the unit sales. However, the most sensitive variable in the investment appraisal of this project is the discount rate a variation in which is likely to result in drastic change in the net present value of the project. The following tabular information also presents the percentage change by which if all of the three variables under consideration increases or decreases, the NPV would be negative and the project would not br worthwhile taking. Unit Sales 13.76% Sales Proceeds 3.33 times Discount rate 19.00% In order to account for various probabilities, it is also advisable to undertake a probability analysis considering various scenarios. Worst Case Particulars Year Now 1 2 3 4 Sales - 144,000 148,320 152,770 157,353 Cost of sales - (90,000) (92,700) (95,481) (98,345) Depreciation Charges - (79,200) (108,000) (36,000) (16,800) Profit before tax - (25,199) (52,378) 21,292 42,211 Taxation - 10,080 20,951 (8,517) (16,885) Profit after tax - (15,119) (31,427) 12,775 25,327 Depreciation Charges (added back) - 79,200 108,000 36,000 16,800 Rent forgone - (20,000) (20,000) (20,000) (20,000) Working Capital (17,280) (518) (534) (17,296) 35,628 Sale proceed from disposal of asset - - - - 25,000 Capital expenditure Invoice amount (200,000) - - - - Shipping charges (10,000) - - - - Installation charges (30,000) - - - - Net Cash flow (257,280) 43,562 56,039 11,479 82,755 Present value factor 1 0.909 0.826 0.751 0.683 Present Value (257,280) 39,602 46,313 8,624 56,523 Net present value (106,217) Best Case Particulars Year Now 1 2 3 4 Sales - 384,000 395,520 407,386 419,607 Cost of sales - (160,000) (164,800) (169,744) (174,836) Depreciation Charges - (79,200) (108,000) (36,000) (16,800) Profit before tax - 144,801 122,722 201,645 227,975 Taxation - (57,920) (49,089) (80,658) (91,190) Profit after tax - 86,881 73,633 120,987 136,785 Depreciation Charges (added back) - 79,200 108,000 36,000 16,800 Rent forgone - (20,000) (20,000) (20,000) (20,000) Working Capital (46,080) (1,382) (1,424) (46,123) 95,009 Sale proceed from disposal of asset - - - - 25,000 Capital expenditure Invoice amount (200,000) - - - - Shipping charges (10,000) - - - - Installation charges (30,000) - - - - Net Cash flow (286,080) 144,698 160,209 90,864 253,594 Present value factor 1 0.909 0.826 0.751 0.683 Present Value (286,080) 131,544 132,404 68,268 173,208 Net present value 219,344 NPV Probability Expected NPV Worst Case (106,217) 0.25 (26,554.35) Best Case 219,344 0.25 54,835.94 Base Case 31,464 0.5 15,731.83 Total expected NPV 44,013.42 Standard Deviation NPV Probability Expected NPV (A) (A-B)^2 (A-B)^2 * P Worst Case (106,217) 0.25 (26,554) 22,569,300,794 5,642,325,198 Best Case 219,344 0.25 54,836 30,740,731,788 7,685,182,947 Base Case 31,464 0.5 15,732 157,496,544 78,748,272 B 44,013 Variance 13,406,256,417 Standard Deviation 115,785 Coefficient of Variation 2.63 As apparent from the above analysis, the project is extremely risky, as the co-efficient of variation is quite high and standard deviation is also quite on the higher side. Now, if it is assumed that the co-efficient of variation of the project is between 0.2 and 0.4, the project would be termed as bearing average risk. It depends upon the discretion of the directors of the company whether they term average risk as equal to their existing (base case) risk. If this is the case, then the directors and financial analyst of the target company do not need to adjust the current cost of capital of the company for risk and accept the project as it has positive NPV. However, if the cost of capital is adjusted for risk, than the revised cost of capital would be 13%. Another method, which is more appropriate for assessing the risk adjusted WACC of the project is calculating the beta through CAPM method. The formula for CAPM is as follows: Where ‘Ke’ is the cost of equity, ‘Rf’ is the risk free rate, ‘Rm’ is the market rate of return and B is the beta of the Project. The directors of the company should look for a project, of any other company in the industry, which is exposed to the same business risk as the Target. Once the directors and financial analyst of the company are able to identify the ‘geared beta’ (measure of the business and financial risk) of the project, they need to ungear the beta by using the following formula In un-levering the beta, the debt to equity ratio of the other company is utilized. The unlevered beta represents only the business risk of the project. But since any project is financed through debt and equity as well, the unlevered beta needs to be levered again. Once un-levered beta is calculated, it is again levered but now by using the debt to equity ratio of the Target. Through this particular exercise Target can calculate the most optimum cost of equity capital for the project by substituting the value in the CAPM formula aforementioned. By incorporating the value of cost of equity into the WACC formula, the risk adjusted WACC of the project can be calculated. In the absence of the above information about the beta of a similar project and other information, it is assumed that the directors of the company have decided to adjust the WACC through the use of co-efficient of co-relation method. In such case, if the WACC of the project is 13%, the following is the NPV, IRR and MIRR of the project. Particulars Year Now 1 2 3 4 Sales - 250,000 257,500 265,225 273,182 Cost of sales - (125,000) (128,750) (132,613) (136,591) Depreciation Charges - (79,200) (108,000) (36,000) (16,800) Profit before tax - 45,801 20,752 96,616 119,795 Taxation - (18,320) (8,301) (38,646) (47,918) Profit after tax - 27,481 12,451 57,969 71,877 Depreciation Charges (added back) - 79,200 108,000 36,000 16,800 Rent forgone - (20,000) (20,000) (20,000) (20,000) Working Capital (30,000) (900) (927) (955) 32,782 Sale proceed from disposal of asset - - - - 25,000 Capital expenditure Invoice amount (200,000) - - - - Shipping charges (10,000) - - - - Installation charges (30,000) - - - - Net Cash flow (270,000) 85,781 99,524 73,014 126,459 Present value factor 1 0.8850 0.7831 0.6931 0.6133 Present Value (270,000) 75,912 77,942 50,603 77,560 Net present value 12,016 IRR 15% MIRR 13% The project is still financially viable, and the company should go ahead with this particular investment. The importance of capital investment decision cannot be ignored in today’s dynamic economy where every company is striving to earn the best return on its investments. Capital investment can be interpreted as an investment venture of considerable larger amount which is on long term basis and is likely to generate revenue for the company over that particular term. In today’s world, a brief analysis will present the fact that companies have separate departments equipped with experts in the fields of financial appraisal and decision making. The sole job of these financial analysts is to identify whether a particular investment is likely to bring inflow or outflow of benefit to the company. While making an investment appraisal decision, it is imperative to consider the impact of inflation in the future cash flow. The case study does not include any relevant information about the price inflation over the five year period which can significantly impact the expected rate of return. The director must also consider the sources from which the financing will be obtained for the investment. Financing decision is significant as the company would have to pay finance charge to the bank or any other financial institution, and the company must have enough cash flows in the future for the payment of these finance charges. [Abeysinghe, R. L., 2010] In order to commence any investment venture, the director must take approval of the shareholders. Although certain investment might appear to be rewarding and worthwhile to invest, do not get shareholders attention that easily. Shareholders, who are often short sighted and tend to ignore the long term feasibility, disapprove the decision of the board based on the fact that the cost of investment will weaken the financial outlook of the organization in the year of the investment. The director while making the investment decision must keep into consideration whether it is of a capital nature or would be reflected in the profit and loss of the company as an expense. Other factors which the directors need to put into consideration are the source of funding for the capital expenditure. In order to finance any project, a company needs to raise capital in the form of revenue funds, short term finance, long term finance, running finance etc. Raising capital can be a significant and crucial task for any company as several technicalities and procedures are involved. It is generally observed in an economic scenario that the company with a good credit history and uplifted financial outlook is likely to raise funds easily as compared to the otherwise. Raising capital significantly affect the gearing of a company. References Abeysinghe, R. L., 2010. Nature and introduction of investment decision. [Online] Available at [Accessed 21 July 2013]. Read More