The Director of Capital Investments - Coursework Example

The Director of Capital Investments Assistant Director of Capital Investments Investment Appraisal December 13, ReportExecutive Summary A number of capital budgeting techniques were employed to determine whether the replacement of an old crane by a new ALII crane would be beneficial investment for FCL. The application of probability theory and sensitivity analysis was used in the determination of the acceptability of the investment. When the company’s discounted rates were used, the results of NPV analysis were negative. The results from the application of the simple payback technique indicated that the additional revenues generated from the use of the ALII crane would be able to pay back for the investment in year 9. However, the application of the IRR technique revealed that the project has an IRR of 20.2% which is less than the rates FCL uses to discount their investments. In consideration of the rate of inflation and the fact that there seem to be no basis for using a 21 per cent and a 26 per cent rate of inflation as suggested in a meeting, the recommendation was made to invest in the project. The basis for this suggestion was that the investment would facilitate an increase in the company’s efficiency. Furthermore, it would help to improve FCL’s image and so allow the company to obtain more contracts and thus increase its revenues. Introduction Investing in a project is not a simple matter. It involves an assessment of different options. If the project relates to an asset for a new idea, this requires consideration of a number of different options which are completely new to the organization. However, if it involves a new piece of equipment to replace an existing one, it requires consideration of the equipment in use compared to the alternative. FCL is considering whether to replace an old crane which has five (5) years left to be put out of commission with a new ALII Crane. The ALII would allow the company to get additional opportunities in the market which the old crane would not be able to facilitate. It would also be able to produce items faster which mean a faster turnaround time and less production backlog for the company. Purchasing a new piece of equipment normally involves a large capital outflow and so the company’s ability to obtain funds is normally one of the main considerations. However, since financing the project is not a challenge, the focus here is not on obtaining money to finance it. Some of the things to be considered include cash flow and the ability of the company to generate enough revenue to make a profit or to break-even with this investment. Additionally, the project needs to be appraised to determine whether the investment will generate the required returns. The project will be assessed in terms of its net present value (NPV) over the ten year period, the payback period and the projects internal rate of return (IRR). Break-even analysis It is important to consider the ability of the company to generate the volume of sales necessary to break-even. The breakeven point is the point at which the company neither makes a profit nor a loss (BPP 2011; Horngren et al. 2000). This is a measure that is frequently used to measure risk in a business (Singh and Deshpande 1982). The ability to generate a profit or to break-even is not the only important issue and so the timing of FCL’s cash flow is also of paramount importance. Cash Flows A projects cash flow is very important. In order to determine the feasibility of the investment the cash flows will have to be evaluated (Emory et al. 2007; Titman et al. 2011). In fact, Popescu (2008) indicates that cash is the lifeblood of a business; therefore, it is important for the people who are placed in authority to pay special attention to cash inflows and outflows and their timing. Cash will flow inwards from sales revenue while cash will flow outwards to pay for expenses that will be incurred on the project. The focus should be on incremental cash flows that are generated from the use of the equipment (Brealy et al. 2004; Keown et al. 2006; Moyer et al. 2006; Ross et al. 2007). Additional factors to be taken into consideration are taxes and deductions that are allowable for taxation purposes. The information relating to cash flows are shown in Appendix 1. The table which is labelled – Table 1 shows the calculation of the net cash flows resulting from the purchase of the replacement asset – the ALII Crane. It shows the capital allowances that are deductible at a rate of 25% on the written down value of the asset each year. This allowance reduces the amount of tax payable. The table also shows the additional tax that would be charged and which would be payable 12 months after the year end to which it relates. Table 3 shows the calculations for the capital allowances. Investment appraisal In this evaluation the main objective is to determine which of the options available to FCL will provide the best return on the company’s investment. Both projects have expenses that are directly attributable to them and so these will be taken into consideration in making a decision on the best option. Capital budgeting techniques will be used to determine the best option. However, the focus will be on the replacement asset and the additional revenues/expenses that it will generate. Capital budgeting is the process by which long term capital expenditures are evaluated (Titman 2011). Among the techniques available to evaluate the investment are the net present value (NPV), simple payback, the internal rate of return and the accounting rate or return (ARR). The NPV, payback period and the IRR are the techniques that will be used in this appraisal process. Net Present Value Analysis The NPV is the most preferred approach to for project evaluation (Ryan and Ryan 2002). Its main focus is the way in which time impacts on the value of money. The net cash flow from a project is therefore discounted at the company’s cost of capital. The NPV is calculated by subtracting cash outflows from cash inflows. The net result is either positive or negative. A positive cash flow indicates that the project will be of benefit to the company in that it will be able to recover the initial investment while a negative cash flow will indicate otherwise. If an investment cannot be recovered, it means that the project is not profitable. It must be noted that NPV can also be zero (0), in which case choosing either option does not matter. An analysis of the additional cash flows from the replacement crane – ALll indicates that the project is not viable when the cash flows are discounted at 26% and 21% as per discussions at the last meeting. If these discount rates are the benchmark for making a decision, the decision to invest in the AL11 crane should not be entertained since the NPV at both discount rates (21% and 26%) are negative. The discount factors were calculated as shown in Table 6 of Appendix 2 Simple Payback period The payback period is the period over which the project will pay back for the initial investment (Emory et al. 2007). This evaluation technique is used a lot because it is a very simple method which was preferred by companies in the past (Ryan and Ryan 2002). However, it is normally used as a starting point in project evaluation. The asset is expected to last for a period of ten years. If a simple payback calculation was done, the project would be able to pay for itself in 9 years as shown in Table 7 in Appendix 3. However, the simple method does not take into consideration the time value of money. It is clear that if the discounted payback period approach is taken then the project will not be able to pay for itself. This is based on the NPV at the end of ten years which is negative at discount rates of 21% and 26%. This is a clear indication that if the time value of money is to be considered then the replacement of the asset should not be done at this time since the extra income that can be generated does not warrant a big investment as represented by the purchase of the ALII Crane. However, Brealy et al. (2004) indicates that the cost of financing is not important in NPV. The simple payback method has been criticised for not taking into consideration the time value of money. However, this can be fixed by using a discount rate. Additionally, there is a concern that it has a bias for short term investments. The criterion used to determine whether the management of FCL should accept the project is based on whether the replacement asset will pay back for itself within ten years. On this basis alone, the project would be accepted. Since it is just a preliminary tool, the NPV becomes critical. Internal Rate of Return (IRR) The internal rate of return (IRR) is the rate at which the NPV is equal to zero (0). In order to determine a rate at which the replacement asset will have an NPV of zero (0) a test which involves trial and error needs to be performed. The IRR is the rate at which the project makes neither a profit nor a loss. The IRR is considered to be one of two superior methods of evaluating projects (Ryan and Ryan 2002). Based on the calculations of the NPV - at discount factors of 21 and 26%, it s clear that the IRR is less than 21%. Using a discounted factor of 20.2% indicates that the IRR is just below 20.2%. This information is shown in Table 8 in Appendix 4. Since the IRR is less then the discounted rate which has been used over the years it might be fair to say that it should be the benchmark. The formula for calculating the IRR is as follows. NPV = CF0 + ((CF1/(1 + IRR)1) + ((CF2/(1 + IRR)2) … ((CFn/(1 + IRR)n) = 0 This calculation involves the use of NPV. Sensitivity Analysis Sensitivity analysis allows for changes to be made in order to determine the impact on the criteria made for decision making. This feature can be employed in Microsoft Excel. It was used to vary the discount rate in order to arrive at the IRR instead of applying the formula. Recommendations and Conclusion According to Emory et al. (2007), the NPV declines as the discount rate increases. The discount rate which is used in project evaluation can lead to the non-acceptance of a project which has the capacity to be beneficial to a company. Businesses prefer to ask whether the project yields a higher return that that which investors expects. The IRR equates the present value of the cash flows that are expected from a project with the present value of the cost that s projected (Brigham and Ehrhardt 2005). The IRR on the project is 20.2% and this rate is lower than the discount rate that has been used by FCL over the years. The current inflation rate is 4% per annum and this is expected to continue for some time. Therefore, if we adjust the cost of capital by the inflation rate, the rate that is arrived at is the rate that should be used to discount the project. However, Delaney (2008) indicates that the cost of capital is not relevant as there are a number of ways in which projects are financed. The NPV calculations indicate that the asset should not be replaced. However, the foregoing information should be taken into consideration. FCL is considered to be a company that keeps up with technology. Sales revenue is falling by 3% per annum which means that there are inefficiencies in production. The company was given an opportunity to earn additional income by taking on an additional contract (Storex contract), but it was not able to due to insufficient capacity. It is expected that by replacing the old crane with the ALII crane FCL will be able to accept new contracts. Additionally, the company will be able to produce more efficiently with less breakdown time and repair costs. Customers like to deal with companies who they contract are reliable. Furthermore, continued use of the old crane will affect the company’s image. I would therefore recommend that FCL replaces the old crane with the ALII Crane. Appendix 1 Calculation of Additional cash Flows after Tax Year Basic (?) Other Less CA (25%) Taxable Tax (35%) Net 0 (345,000)         (345,000) 1 88,000 15,000 (86,250) 16,750 5,863 97,138 2 88,000 15,000 (64,688) 38,313 13,409 89,591 3 88,000 15,000 (48,516) 54,484 19,070 83,930 4 88,000 15,000 (36,387) 66,613 23,315 79,685 5 88,000 15,000 (27,290) 75,710 26,498 76,502 6 88,000 15,000 (20,468) 82,532 28,886 74,114 7 88,000 15,000 (15,351) 87,649 30,677 72,323 8 88,000 15,000 (11,513) 91,487 32,020 70,980 9 88,000 15,000 (8,635) 94,365 33,028 69,972 10 88,000 15,000 (6,476) 96,524 33,783 69,217 Additional Cash Flows from ALll - Three Scenarios   Year Best (?) Likely (?) Worst (?) 0 (345,000) (345,000) (345,000) 1 160,000 80,000 40,000 2 160,000 80,000 40,000 3 160,000 80,000 40,000 4 160,000 80,000 40,000 5 160,000 80,000 40,000 6 160,000 80,000 40,000 7 160,000 80,000 40,000 8 160,000 80,000 40,000 9 160,000 80,000 40,000 10 160,000 80,000 40,000 Probability 20% 60% 20%     Weighted Cash Flow Year Best (?) Likely (?) Worst (?) Total 0 (69,000) (207,000) (69,000) (345,000) 1 32,000 48,000 8,000 88,000 2 32,000 48,000 8,000 88,000 3 32,000 48,000 8,000 88,000 4 32,000 48,000 8,000 88,000 5 32,000 48,000 8,000 88,000 6 32,000 48,000 8,000 88,000 7 32,000 48,000 8,000 88,000 8 32,000 48,000 8,000 88,000 9 32,000 48,000 8,000 88,000 10 32,000 48,000 8,000 88,000 Table 2 Other Savings from not using old machine:   Selling price 20,000 Lost income (15,000 x 3 days) 45,000 Repair cost 10,000   75,000 Less: Running cost of ALll Crane 60,000 Net cash inflow 15,000 Table 3 Calculation of Capital Allowances Year Old Machine New Machine Balance (?) CA (25%) Balance (?) CA (25%) 1 150,000 37,500 345,000 86,250 2 112,500 28,125 258,750 64,688 3 84,375 21,094 194,063 48,516 4 63,281 15,820 145,547 36,387 5 47,461 11,865 109,160 27,290 6 35,596 8,899 81,870 20,468 7 26,697 6,674 61,403 15,351 8 20,023 5,006 46,052 11,513 9 15,017 3,754 34,539 8,635 10 11,263 2,816 25,904 6,476 Table 4 Appendix 2 FCL - Net Present Value Analysis Scenario 1 Year Cash Flow Discount Factor (26%) Discounted Cash Flow 0 (345,000) 1.0000 (345,000) 1 97,138 0.7937 77,093 2 89,591 0.6299 56,431 3 83,930 0.4999 41,957 4 79,685 0.3968 31,615 5 76,502 0.3149 24,089 6 74,114 0.2499 18,521 7 72,323 0.1983 14,344 8 70,980 0.1574 11,173 9 69,972 0.1249 8,742 10 69,217 0.0992 6,863 NPV 438,450   (54,171)   Scenario 2 Year Cash Flow Discount Factor (21%) Discounted Cash Flow 0 (345,000) 1.0000 (345,000) 1 97,138 0.8264 80,279 2 89,591 0.6830 61,192 3 83,930 0.5645 47,377 4 79,685 0.4665 37,174 5 76,502 0.3855 29,495 6 74,114 0.3186 23,615 7 72,323 0.2633 19,045 8 70,980 0.2176 15,447 9 69,972 0.1799 12,585 10 69,217 0.1486 10,289 NPV 438,450   (8,504) Table 5 Calculation of discount factor Year Calculation (Last year's factor x year 1 factor) Discount factor 0   1.0000 1 1 x [100/100+ 26] 0.7937 2 0.9091 x 0.9091 0.6299 3 0.8265 x 0.9091 0.4999 4 0.7513 x 0.9091 0.3968 5 0.6830 x 0.9091 0.3149 6 0.6209 x 0.9091 0.2499 7 0.5645 x 0.9091 0.1983 8 0.5132 x 0.9091 0.1574 9 0.4665 x 0.9091 0.1249 10 0.4241 x 0.9091 0.0992 Table 6 Appendix 3 Calculation of Payback Year Cash Flow Cumulative Total 0 (345,000) (345,000) 1 97,138 (247,863) 2 89,591 (158,272) 3 83,930 (74,341) 4 79,685 5,344 5 76,502 81,845 6 74,114 155,959 7 72,323 228,282 8 70,980 299,261 9 69,972 369,234 10 69,217 438,450 Table 7 Appendix 4 Calculation of IRR - Using trial and error Year Cash Flow Discount Factor (20.2%) Discounted Cash Flow 0 (345,000) 1.0000 (345,000) 1 97,138 0.8319 80,813 2 89,591 0.6921 62,009 3 83,930 0.5758 48,329 4 79,685 0.4791 38,173 5 76,502 0.3985 30,489 6 74,114 0.3316 24,574 7 72,323 0.2758 19,950 8 70,980 0.2295 16,289 9 69,972 0.1909 13,359 10 69,217 0.1588 10,994 NPV     (20) Table 8 References BPP (2011a). Paper F2 Management Accounting. London: BPP Learning Media Brealey, R.A., Myers, S.C. and Marcus, A.J. (2004). Fundamentals of Corporate Finance. 4th ed. New York: McGraw-Hill/Irwin Brigham, E.F. & Ehrhardt, M.C. (2005). Financial Management: Theory and Practice. 11th ed. USA: Thomson South-Western Delaney, C.J., Rich, S.P and Rose, J.T. (2008). Financing Costs and NPV Analysis in Finance and Real Estate. Journal of Real Estate Portfolio Management, 14(1), p. 35 - 39 Emery, D.R., Finnerty, J.D. and Stowe, J.D. (2007). Corporate Financial Management. 3rd ed. USA: Prentice Hall Horngren, C.T., Foster, G and Datar, S.M. (2000). Cost Accounting: A Managerial Emphasis. NJ: Prentice Hall Keown, A.J. Martin, J.D., Petty, J.W and Scott, D.F. (2006). Foundations of Finance. 5th ed. New Jersey: Pearson Prentice Hall Moyer, R.C. McGuigan, J.R and Kretlow, W.J. (2006). Contemporary Financial Management. 10th ed. Ohio: Thomson South Western Popescu, A. (2008). Study upon the Role of Cash Flow Analysis in Financial Management. Scientific Papers, 8(2), p. 274 – 278. http://www.managusamv.ro/fisiere/file/Lucrari%20Vol%208(2)%202008.pdf#page=122 Ross, S.A., Westerfield, R.W and Jordan, B.D. (2007). Essentials of Corporate Fnance. 5th ed. New York: McGraw-Hill/Irwin Ryan, P and Ryan, G. (2002). Capital Budgeting Practices of the Fortune 1000: How Have Things Changed? Journal of Business and Management, 8(4), p. 282 - 286 Singh, S.P and Deshpande, J.V. (1982). Break-Even Point. Economic and Political Weekly, 17(48), p. 123 - 128 Titman, S., Martin, J.A and Keown, A. (2011). Financial Management: Principles and Application. 11th ed. USA: Prentice Hall Read More