Tesco: Evaluating The Cost Of Two Compressors That Will Be Used In The Refrigerator - Case Study Example

? Summary The project analysis is based on evaluating the cost of two compressors that will be used in the refrigerator and ascertain if the project is work investing. Meanwhile, the analysis focuses on the various capital budgeting techniques that are used to evaluate the significant of the project. The analysis deals with the average demand scenario that indicates the sensitivity of the project and if the project should be accepted based on the risk involved in implementing the project. The paper evaluates the behavior of cash flows for the next 20 years and examines the assumption used to forecast the cash flows. Meanwhile, the paper evaluates cost of equity that is used to keep a share price that is essential to investors to evaluate the performance of various projects. On the basis of the various evaluation of the project, we recommend the way forward for the Tesco works. Question1 The energy cost situation should be considered of the significant in evaluating the feasibility of the project in the competitive market. The productivity of the projects will depend on the energy cost situation. In case, the energy costs are high the project will be extremely expensive that will have inadequate return. Understanding the cost effectiveness of the energy cost will assist indicate the significant of implementing energy cost in the project plan. The energy efficiency cost efficacy is ascertained by comparing the benefits of investments with the costs. The significant of the energy cost situation will be evaluated using overall cost effectiveness of the energy efficiency. The discount rate used to discount, the NPV of the annual costs and benefits is obtained and evaluated. Given that the energy cost will occur upfront and the returns occur over time, the lower discount rate will prove the cost effectiveness will be positive. Since this is the business project, the discount rate will be the weighted average cost of the capital that is approximately 12 percent. The WACC equation is the cost of each capital constituent multiplied by its proportional weight and then adding as shown in the spreadsheet. The calculate WACC is approximately 11.6 percent that is lower than the discount rate and indicate there is significant of energy cost situation. The benefit is positive that indicate the project is cost effectiveness in future. Question 2 The project cost of equity is initially what the business to keep a share price that is essential to investors to evaluate the performance of the projects. According to Pratt and Grabowski (2010), the most frequently used method for calculating cost of equity is based on the capital asset pricing model where cost of equity is given by risk free rate plus beta multiplied by equity market risk premium. The cost equity is approximately 14.45 percent that can be adjusted to increase or decrease the risk taken by the business on the investment projects. Thus, the appropriate discount factor to use when evaluating the refrigerator is the WACC that is approximately 11.6. The WACC is used to evaluate the refrigerator project because it comprises both the cost of equity and the cost of debt of the project that are vital in determining the feasibility of the project. Meanwhile, using the 11.6 percent has a discount rate it will be essential in evaluating the NPV of investment outlays of the project that will be used to establish the profitability of the project in the future. Question 3 The evaluation of the present value calculated under the warranty cost will indicate which of the two compressors should be used in the refrigerator. The compressor with higher warranty cost is cheaper to implement, and the one with lower warranty cost is expensive to implement. Thus, we will evaluate the present value criteria to ascertain which of the two compressors is best to be used in the refrigerator. The present value of the MC – 004 and TS – L12 are both equal has calculated in the spreadsheet for both scenarios. Thus, the compressor with the highest present value is the best to be used in the refrigerator and continue with the need to implement the project. The TS – L12 compressor has the highest present value that indicates the business can use it in their refrigerators. Meanwhile, the TS – L12 has higher warranty cost that shows it will cheaper and viable for the business to use it in the refrigerator. Question 4 The forecasted cash flows of the project in the next 20 years are indicated in the spreadsheet, and show the trend from the first year was positive. The positive trend of forecasted cash flows indicates that the project will be beneficial in the subsequent years and will be viable. While predicating the cash flows, we made the assumptions that the discount rate used throughout 20 years was approximately 11.6 percent, and it did not change during the period. Meanwhile, we made the assumption that the price for the sales did not fluctuate, but remained constant during the forecasted period. When forecasting the cash flows, we assumed that the depreciation rate was established on the straight line basis and remained constant for the three years. Reider and Heyler (2003) indicate that the taxes on operating profit were assumed to be constant and depended on revenue obtained from the selling the product assist in examining the significant of implementing the project in the business (Michael, 2010). In order to forecast the cash flows, it is vital to hold all factors that were used to calculate the operating cash flows constant to avoid misleading information. Question 5 In order to determine the feasibility and productivity of the refrigerator for the business that they want to implement, we should analyze the criteria used to choose the best alternative based on the three capital budgeting techniques. The IRR methods give results that are related with the NPV. The outcomes depend on the theory that if the initial investment is negative the rest will be negative. The projects that have a higher total cash flow but pays back more slowly will have a higher NPV (Michael, 2010). The IRR for the project in the three scenarios is lesser than 11.6 percent rate used to discount the investment outlays of the refrigerator. The NPV for the refrigerator is greater than one that shows the project is viable. Meanwhile, the payback period of the project is less than the critical acceptance level of 20years of the project. The calculation of the profitability index of the project will help in evaluating the significant of implementing refrigerator in the business (Michael, 2010). In case, the profitability index is equal or greater than 1 the project will be beneficial to the investors. The profitability index will enable to evaluate the proportion of dollars generated to dollars invested in the project. Thus, the profitability index of the project in the average and strong scenarios is greater than one and that means the project will help the business to meet its goal of implementing the project. The weak demand level has a profitability index that is less than one that indicate the project will not be viable in the low demand, in the market. The profitability index is approximately 1.38 and shows the project is Viable. The Company should take into consideration of implementing the project to that gaining the returns at the end of the 9 year. Question 6 The average demand scenario analysis can help the business to evaluate the sensitivity of the projects net present. The evaluation will consider the cost of the refrigerator and the cost of the compressors that are going to be used in the refrigerator. The price of the refrigerator depends directly on the cost of the compressors. The curves on the spreadsheet indicate that when the cost of the compressor is high, the sale of refrigerator decreases and when cost decreases the price of refrigerators increases. Walter and Haslett (2010) indicate that the average demand on NPV of the project should be accepted because it does not depend on the valuable real option. The refrigerator has two years until maturity that is a long period, and the cash flows of the project are extremely sensitive. Thus, the sale of the refrigerator is extremely sensitivity to the cost of the compressors as shown in the graph. Question 7 When the higher rate of discount is used to discount the cash flows, there is a possibility that the NPV will be negative. Although, the 12% show that the project is healthier to invest to invest, the margin is a bit lower for any company to invest because the analysis was based on the weighted average on NPV. Thus, the weighted average on NPV of the TS – L12 is lower than that of the MC – 004 and indicates the TS – L12 is less sensitivity to the price of refrigerator. Brigham and Daves (2010) indicate that the average demand scenario does not consider the valuable real option that indicates the current cash inflows will be higher than that of the future years. The reduction of cash flows in the future years indicate that the project will be risky to invest, but the positive trend of the project is proved the viability of the project. Question8 I would recommend Tesco works accept the project because the payback period of the project in both demand level scenarios is less than the predicted 20 years. This shows the project will be profitable in a shorter period than it was predicted, and the net present value of the project is positive and greater than one that indicates the viability of the project in the market. Meanwhile, the sensitivity analysis of the project indicates that the Tesco works will sale sufficient refrigerators when the cost of the compressor is low. Thus, the sensitivity establishes the equilibrium that will be reasonable for the Tesco works. The warranty cost of the TS – L12 compressor is higher than that of MC – 004 that means Tesco works can use the TS – L12 in the refrigerator because it is cheaper and viable. The cash flows forecasted indicate a positive trend for the subsequent years that shows the project will stand the competition in the market in the future. References Brigham, E., Daves, P. (2010). Intermediate Financial Management. Mason, OH: Cengage Learning Press.  Michael, P. (2010). Investment Appraisal: Corporate investment Decisions Principle and Practice. New York: Business Expert Press. Pratt, S. , Grabowski, R. (2010). Cost of Capital: Applications and Examples. United Kingdom: John Wiley and Sons. Reider, R., Heyler, P. (2003). Managing Cash Flow: An Operational Focus. New York: John Wiley and Sons Inc. Walter, V., Haslett, J. (2010). Risk Management: Foundations for a Changing Financial World. New York: John Wiley and Sons. Read More