Financial Decision Making and Risk Analysis - Case Study Example

Financial Decision Making and Risk Analysis Case Facts and Summary The company is investigating the possibility of replacing its current sub-assemblyline with an automated assembly cell. The new assembly cell will consist of five new robots, each costing £32,000, with associated gripping devices costing a total of £65,000. The roller tracking plus the assembly fixtures, etc. would cost an additional £15,000. The new cell will replace the existing sub-assembly line which requires eight fitters at a cost of £18,500 per annum each. It is estimated that the reduction in scrap and rework would save an additional £5,000 per year. The new assembly cell requires three cell programmer/operators recruited at a salary of £20,000 per year each. The cell robots are expected to last for 5 years, after which they can be sold off for an estimated price of £1,000 each. The company’s cost of capital is currently 10%. This paper is a detailed report evaluating the proposed investment. Based on an analysis of the investment options, we recommend that we go ahead with the investment for the following main reasons: First, we would generate savings of £230,000 over five years that would maximise shareholder value. Second, taking into account the time value of money, the investment is a prudent use of our resources. Third, the investment shows high positive rates of return and a payback of three to four years, allowing us to recover our capital investments in a reasonable period of time. What follows is a detailed financial analysis of the investment proposal supporting our recommendation and all potential problems foreseen with their corresponding solutions. Case Analysis This is a two-option financial investment appraisal case which compares the cost of operating an existing sub-assembly line with the cost of a new automated assembly cell. Both options incur costs we could compare to find out which option results in lower expenses over the next five years. Any savings will increase profits, which we can then transform into additional value that would benefit our shareholders. As shown in the case facts in Table 1, our existing line costs us £153,000 per year in personnel and scrap costs. The total expenses amount to £765,000 over five years. The proposal is to replace this with an automated line that cost £535,000 over the same period, for a total savings of £230,000; but we need to invest £240,000 now. We utilised common investment criteria to analyse this project, and considered other factors that may affect its financial viability. We included our suggested solutions and potential effects on the final decision through a sensitivity analysis, which takes into account: 1. The cost of replacing our eight fitters and with three skilled operators. We included the effect of granting separation pay to each displaced operator and made a recommendation on how much we could afford to pay. 2. The optimal cost of capital when the investment loses its viability. This gives us an idea of how much interest rate fluctuations we can tolerate for this investment. 3. The possibility of financing the investment with debt at different costs of capital. We recommended the level of borrowing, interest rates, and the trade-offs we need to discuss further. These scenarios allow us to determine the level of debt financing we can tolerate without affecting the attractiveness of the investment. The key insight to our problem is to match the cash flows for both options. Option 1 is our existing sub-assembly line, whilst Option 2 would be our proposed investment in new automated machines. Each option has a cash outflow over the next five years. Whilst Option 1 would not require a large cash outflow now, it has the same level of cash flows we are currently spending to maintain the line. In contrast, Option 2 demands a large cash outflow now, but this would result in lower cash flows over the next five years. We compared both cash flow forecasts and arrived at a net cash flow, which is the amount of working capital we would save from the lower cash requirements of Option 2. A basic assumption is that the sub-assembly line’s productivity would be constant, and that Option 2 would not decrease our production output. Cash Flow Forecast The cash flow forecast is shown in Table 2. Option 1 has a total cash flow of £765,000 over five years. Option 2 has a total cash flow of £535,000 which already includes the initial investment. Just on this basis alone, we can see that investing in Option 2 would save our company £230,000 over five years. To arrive at the net cash flow, which would be the basis for our calculations of the investment’s attractiveness, we calculate the total savings by subtracting the cash flows of Option 2 from the cash flows of Option 1. This gives us an idea of how much we save each year from the investment. The last line in Table 2 shows us the net cash flow. Next, we analyse our investment using several financial appraisal techniques. Financial Investment Appraisal Techniques Accountants and financial managers have several methods of appraising investment decisions to determine whether an investment would be profitable for the corporation. The most common method uses discounted cash flow (DCF), which considers the time value of money (Fisher, 1965; Hirschleifer, 1958) and the opportunity cost of capital. There are two DCF methods (Fama and Miller, 1972) that attempt to capture this opportunity cost of capital: Net Present Value (NPV) and Internal Rate of Return (IRR) The basic DCF formula is as follows (Figure 1): The value of DCF is equivalent to the initial investment required. Where NPV and IRR differ is in the way we go about computing the right side of the equation. In NPV, the values of the cash flows for each period (usually at year-end) and the discount rate (r, which is equal to our cost of capital) are known. The cash flows and discount rates may change every year. The variable n is the last year for which the cash flow is generated. In our case, r = 10% and n = 5. Whilst the NPV computes for the difference between the investment today and the cash flow tomorrow, with a positive result meaning the investment will have a higher value and should be accepted (and if negative, the investment must be rejected), the IRR calculates the rate of return r for which the two cash flows – the investment today and the discounted future cash flow – are equal. Looking at our DCF formula, we know the left hand side (investment needed) and the CF values on the right, but we do not know the value of r. IRR uses trial and error to compute for r. If this internal rate of return for the investment project is higher than the cost of capital, the investment is worth accepting. NPV and IRR are the two most common methods of investment appraisal. We made our computations using the built-in formulas in the Excel worksheet. Net Present Value (NPV) and Internal Rate of Return (IRR) Table 3 summarises our NPV calculation, which shows that the project has a positive NPV of £105,134 during the period and is therefore worth pursuing. We derived this value by getting the sum of the discounted cash flows (savings) for five years at a rate of return equal to the cost of capital of 10% and subtract the initial investment required from this sum. What the NPV shows is that our savings from investing in Option 2 would be greater than the initial investment required. Table 3 also shows us the IRR as 27.4%, almost three times our 10% cost of capital. Therefore, using NPV and IRR criteria, the project Option 2 is viable and shows that it enables the company to earn above the opportunity cost of capital. Payback, Discounted Payback, and Capital Recovery Another common investment appraisal method concerns calculating the number of years needed to recover the capital invested in the business. This is the reason behind the Payback Rule, which is based on the expectation that any project must recover its initial outlay within some specified period. The payback period is found by counting the number of years it takes before cumulative forecasted cash flows equal the initial investment. Its strength is its simplicity, but it suffers from a major weakness: it does not account for the time value of money. Therefore, it does not inform the investor whether the invested funds earned higher than the opportunity cost of capital (Lefley, 1996). This is where we can use Discounted Cash Flow Payback, where the discounted cash flows are used to compute the number of years needed to recover the investment. From Table 4, we compute for the Payback and Discounted Payback and find the answers to be 3 and 4 years, respectively. Using the basic Payback rule, we can recover our initial investment in three years, whilst taking into account the time value of money and discounted cash flows, it would take us four years to recover our investment. Since machines are good for five years, we have one to two more years to operate the machine profitably. Return on Investment Return on investment (ROI) or the accounting rate of return is the ratio of after-tax operating income to the net depreciated book value of assets. ROI depends on accounting figures and disregards the time value of money. Whilst Payback gives undue weight to cash flow in the first years of the project, ROI gives too much weight to distant period cash flows. ROI depends on accounting income and not project cash flows, and includes depreciation, an accounting and not a cash transaction, bringing down ROI and profitability. We show two calculations in Table 5. ROI considers only the total cash inflow amounting to £470,000 from the investment of £240,000. This gives us a ROI figure of 196%. The second, Book ROI, takes into account the Book Income which is lower due to depreciation, amounting to £310,000. This gives us a Book ROI of 129%. Either way, ROI figures over 100% show that we can recover the capital cost of our investment from the savings generated. Sensitivity Analysis Identifying major uncertainties and risks would help the company make a decision whether to study or push through with a project, thus avoiding getting caught by surprise if things go wrong and helping us prepare and be ready to take corrective action. In Sensitivity Analysis (SA), we identify several variables of a project’s success and estimate how far the present value of the project would be changed by taking a very optimistic or very pessimistic view of each variable (Hertz, 1968). Sensitivity analysis looks at different scenarios and allows us to forecast the effects of changes in our assumptions on the attractiveness of our investment. We identified three scenarios and show our calculations in Table 6. Scenario 1 assumes our displaced fitters would ask for separation pay. Computations showed we can afford to give up to 75% of annual pay and our project would still be viable. Scenario 2 assumes our cost of capital may change. Scenario 2.1 shows that if cost of capital goes up to 27%, the project would still have a positive NPV, which means it continues to be financially viable. However, such a macroeconomic event would affect sales and other costs due to inflation, effects beyond the purpose of this study, which would have an impact on net cash flows and investment viability. Scenario 2.2 is an extension of computations in Scenario 1 and shows that if we decide to pay our fitters the amount we forecast, we have to ensure our cost of capital does not go above the current 10%. If it does, we can afford less than the £115,000 at which point the investment continues to remain viable. If, for one reason or other, cost of capital goes up to 12%, the amount we can pay our fitters would drop to £98,000 as shown in Scenario 2.3. Scenario 3 assumes that part of our investment is funded from debt. Scenario 3.1 shows that borrowing 100% of our investment at the 10% cost of capital would burden us with principal and interest payments that make the project non-viable. Scenario 3.2 shows the level of debt financing we can use for the investment: 43% or £103,200. However, we assumed we would not give separation pay. What happens if we decide to give separation pay and use debt for part of our financing? We show this in Scenario 3.3, which indicates one combination of separation pay and the portion of the investment that could be financed by debt at a 10% interest rate. If we give one month’s salary, we can borrow up to 35%, but giving three months would reduce the amount we can borrow to 21%. These are the scenarios considered, with NPV serving as our common take-off point for our calculations. By plugging different values for certain variables, we can find different reference points that enable us to analyse the financial consequences of our decisions. Graphing the Decision The graph in Figure 2 captures the cash flow from the two options. The total savings from Option 2 is shown as the yellow area. We found this amount as £230,000 over the 5-year period. Another graph (Figure 3) shows clearly that between the second and third years of our project, we would be spending less cash than what we are spending now. Summary of Recommendations Based on our calculations, the investment in Option 2 which calls for spending on new automated cell equipment is financially viable. It would save us cash we could use for other projects, provide us with a return that is above our 10% cost of capital, allow a payback period of three to four years, and offer us a good return on our investment. We recommend that the Board discuss the following: 1. How much to give workers displaced by the investment; and 2. Consider financing a portion of the investment with debt at a reasonable rate. The calculations for various scenarios related to these issues are included in this report, with appropriate suggestions that show how these would affect the financial viability of the investment. Reference List Anthony, R.N., Reece, J.S., and Hertenstein, J.H. (2005). Accounting text and cases. London: Irwin. Bierman, H. and Smidt, S. (1992). The capital budgeting decision (8th ed.). New York: Macmillan. Brealey, R.A. and Myers, S.C. (2003). Principles of corporate finance (7th ed.). New York: McGraw-Hill. Damodaran, A. (2006). Damodaran online: Investments. Available from: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invemgmt/invmg.htm [Accessed 24 November 2006]. Elton, E.J., Gruber, M.J., Brown, S. J. and Goetzmann, W. N. (2003). Modern Portfolio Theory and Investment Analysis (6th Ed.). New York: Wiley & Sons. Fama, E. F. and Miller, M. H. (1972). The theory of finance. New York: Holt, Rinehart, and Winston. Fisher, I. (1965). The theory of interest (Reprinted 1930 edition). New York: A.M. Kelley. Hertz, D.B. (1968). Risk analysis in capital investment. Harvard Business Review, 42 (1), 95-106. Hirschleifer, J. (1958). On the theory of optimal investment decision. Journal of Political Economy, 66 (August), 329-352. Lefley, F. (1996). The payback method of investment appraisal: A review and synthesis. International Journal of Production Economics, 44(3), 207-224. Pike, R. and Neale, B. (2003). Corporate finance and investment: decisions and strategies (4th ed.). New York: Prentice Hall. Weighted Average Cost of Capital (WACC). (2006) Investopedia.com. Available from: http://www.investopedia.com/terms/w/wacc.asp [Accessed 24 November 2006]. List of Tables Table 1. Case Facts Summary. Table 2. Cash Flows Forecast. Table 3. Net Present Value (NPV) and Internal Rate of Return (IRR) Calculations. Table 4. Payback and Discounted Payback Calculations. Table 5. Return on Investment (ROI) Calculations. Table 6. Sensitivity Analysis with Three Scenarios. List of Figures Figure 1. Basic Discounted Cash Flow (DCF) Formula – see page 4. Figure 2. Graph Showing Savings from Option 2. Figure 3. Graph Showing Cash Flows from Options 1 and 2. Table 1. Case Facts Summary. Option 1 Item Unit, £ Total, £ Notes Fitters 18,500 148,000 For 8 fitters, to be displaced by new equipment   Scrap   5,000 Annual savings from scrap/rework     Option 2 Item Unit, £ Total, £ Notes Robots 32,000 160,000 For 5 units         Grippers   65,000 Total for all 5 units         Fixtures   15,000 Fixtures for all 5 units       Operators 20,000 60,000 For 3 operators         Salvage 1,000 5,000 Proceeds from sale of fully depreciated units after 5 years Capital 10%   Assumed cost of capital       Table 2. Cash Flows Forecast. Statement of Cash Flows (in £) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Totals Item Unit Total Option 2 Robots 32,000 160,000 (160,000)             Grippers 65,000 (65,000)         Fixtures 15,000 (15,000)         Operators 20,000 60,000   (60,000) (60,000) (60,000) (60,000) (60,000)   Salvage 1,000 5,000       5,000   Cost Cap 10%             Totals: (240,000) (60,000) (60,000) (60,000) (60,000) (55,000) (535,000)             Option 1 Fitters 18,500 148,000   (148,000) (148,000) (148,000) (148,000) (148,000)   Scrap 5,000   (5,000) (5,000) (5,000) (5,000) (5,000)                 Totals: 0 (153,000) (153,000) (153,000) (153,000) (153,000) (765,000)                 Net cash flow: (240,000) 93,000 93,000 93,000 93,000 98,000 230,000 Table 3. Net Present Value (NPV) and Internal Rate of Return (IRR) Calculations. NPV and IRR (Amounts in £) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Totals Option 2 Robots 32,000 160,000 (160,000)             Grippers   65,000 (65,000)             Fixtures   15,000 (15,000)             Operators 20,000 60,000   (60,000) (60,000) (60,000) (60,000) (60,000)   Salvage 1,000 5,000           5,000   Cost Cap 10%                     Totals: (240,000) (60,000) (60,000) (60,000) (60,000) (55,000) (535,000)                     Option 1 Fitters 18,500 148,000   (148,000) (148,000) (148,000) (148,000) (148,000)   Scrap   5,000   (5,000) (5,000) (5,000) (5,000) (5,000)                           Totals: 0 (153,000) (153,000) (153,000) (153,000) (153,000) (765,000)                         Net cash flow: (240,000) 93,000 93,000 93,000 93,000 98,000 230,000                         Discount Factor:   1.10 1.21 1.33 1.46 1.61                           Discounted Cash Flow:   84,545 76,860 69,872 63,520 60,850 355,648                         NPV:   £115,648               IRR:   27.4%           Table 4. Payback and Discounted Payback Calculations. Initial Investment 240,000           Payback 3 years 279,000   Discounted Payback 4 years 294,797 From Table 3 Discounted Cash Flows Table 5. Return on Investment (ROI) Calculations. Year 1 Year 2 Year 3 Year 4 Year 5 Cash flow   93,000 93,000 93,000 93,000 98,000 Book Value, start 160,000 128,000 96,000 64,000 32,000 Book Value, end 128,000 96,000 64,000 32,000 0 Book Value, change (32,000) (32,000) (32,000) (32,000) (32,000) Book income 61,000 61,000 61,000 61,000 66,000 Computation of Book ROI Book ROI 38% 48% 64% 95% 206% Book ROI Income   310,000       Investment   240,000       Book ROI   129% over the life of the investment Basic ROI ROI Savings   470,000         Investment   240,000       ROI   196%       Table 6. Sensitivity Analysis with Three Scenarios (Page 1 of 2). Scenario 1: Separation Pay Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Totals     Net cash flow: (240,000) 93,000 93,000 93,000 93,000 98,000 230,000     Separation Pay: (115,000)                 Net cash flow: (355,000) 93,000 93,000 93,000 93,000 98,000                           Per fitter: 14,375         NPV 589     % of Salary: 78%         IRR 10% Scenario 2: Change in cost of capital Year 1 Year 2 Year 3 Year 4 Year 5 NPV 2.1   Cost of capital: 27%                 Net Cash Flow: (240,000) 93,000 93,000 93,000 93,000 98,000 1,340                 IRR: 27% 2.2   Cost of capital: 10%                 Net Cash Flow: (355,000) 93,000 93,000 93,000 93,000 98,000 589                 IRR: 10% 2.3   Cost of capital: 12%                 Separation Pay: (98,000)                 Net Cash Flow: (338,000) 93,000 93,000 93,000 93,000 98,000 73 Table 6. Sensitivity Analysis with Three Scenarios (Page 2 of 2). Scenario 3: Debt financing Year 1 Year 2 Year 3 Year 4 Year 5 NPV 3.1   %-age debt: 100%                 Interest Rate: 10%                 Repayments:   (48,000) (48,000) (48,000) (48,000) (48,000)       Loan Balance:   (192,000) (144,000) (96,000) (48,000) 0       Interest:   (24,000) (19,200) (14,400) (9,600) (4,800)       Net cash flow: (240,000) 21,000 25,800 30,600 35,400 45,200 (113,047) 3.2   %-age debt: 43% 103,200               Interest Rate: 10%                 Repayments:   (20,640) (20,640) (20,640) (20,640) (20,640)       Loan Balance:   (82,560) (61,920) (41,280) (20,640) 0       Interest:   (24,000) (8,256) (6,192) (4,128) (2,064)       Net cash flow: (240,000) 48,360 64,104 66,168 68,232 75,296 10 3.3   %-age debt: 21% 57,960               Interest Rate: 10%                 Separation Pay: (36,000)                 Repayments:   (11,592) (11,592) (11,592) (11,592) (11,592)       Loan Balance:   (46,368) (34,776) (23,184) (11,592) 0       Interest:   (27,600) (4,637) (3,478) (2,318) (1,159)       Net cash flow: (276,000) 53,808 76,771 77,930 79,090 85,249 1,696 Figure 2. Graph Showing Savings from Option 2. Figure 3. Graph Showing Cash Flows from Options 1 and 2. Read More