Marine Finance and Insurance - Coursework Example

TOWERS Plc Net Cash Flows, Year 6 Year 2 3 Increased in Sales Volume 800,000 400,000 2,000,000 Increased in $ Sales1 $ 32,800,000.00 $ 57,400,000.00 $ 82,000,000.00 Increased in Variable Cost2 $ 25,600,000.00 $ 44,800,000.00 $ 64,000,000.00 Increased in Admin Cost3 $ 2,560,000.00 $ 4,480,000.00 $ 6,400,000.00 Contribution Margin4 $ 4,640,000.000 $ 8,120,000.00 $ 11,600,000.00 Depreciation5 $ 4,333,333.33 $ 4,333,333.33 $ 4,333,333.33 Additional Fix Overhead $ 1,750,000.00 $ 1,750,000.00 $ 1,750,000.00 Estimated Earnings6 $ (1,443,333.33) $ 2,036,666.67 $ 5,516,666.67 Add Back Non-Cash Outlay7 $ 4,333,333.33 $ 4,333,333.33 $ 4,333,333.33 Cash Flow from Operations8 $ 2,890,000.00 $ 6,370,000.00 $ 9,850,000.00 Total Projected Cash Flow $ 2,890,000.00 $ 6,370,000.00 $ 9,850,000.00 Present Value Rate .8772 .7695 .6750 Discounted Cash Flows $ 2,535,088.00 $ 4,901,508.16 $ 6,648,469.43 Year 4 5 6 Increased in Sales Volume 2,200,000 2,000,000 400,000 Increased in $ Sales/Year $ 90,200,000.00 $ 82,000,000.00 $ 16,400,000.00 Increased in Variable Cost $ 70,400,000.00 $ 64,000,000.00 $ 12,800,000.00 Increased in Admin Cost $ 7,040,000.00 $ 6,400,000.00 $ 1,280,000.00 Contribution Margin $ 12,760,000.00 $ 11,600,000.00 $ 2,320,000.00 Additional Fixed Overhead $ 1,750,000.00 $ 1,750,000.00 $ 1,750,000.00 Depreciation $ 4,333,333.33 $ 4,333,333.33 $ 4,333,333.33 Estimated Earnings $ 6,676,666.67 $ 5,516,666.67 $ (3,763,333.33) Add Back Non-Cash Outlay $ 4,333,333.33 $ 4,333,333.33 $ 4,333,333.33 Cash Flow from Operations $ 11,010,000.00 $ 9,850,000.00 $ 570,000.00 Salvage Value8 $ 2,900,000.00 Inflow from Working Capital9 $ 3,300,000.00 Total Projected Cash Flow11 $ 11,010,000.00 $ 9,850,000.00 $ 6,770,000.00 Present Value Rate12 .5921 .5194 .4556 Discounted Cash Flows13 $ 6,518,803.85 $ 5,115,781.34 $ 3,084,320.93 SUPPORTING CALCULATIONS /EXPLANATIONS (Please see attached spreadsheet): 1 The increased in sales is the increased in sales volume multiplied by the selling price/unit, $41. 2Increased in Variable cost is the increased in sales volume multiplied by the variable cost, $32. 3Increased in Admin Cost is the increased in sales volume multiplied by the admin cost per unit, $3.20. 5Depreciation is computed using straight-line method: increased in investment/estimated useful life or $26,000,000/6= 4,333,333.33. We do not deduct the salvage value because it is not considered for tax depreciation purposes under the Modified Accelerated Cost Recovery System. Although depreciation is higher, this does not reduce cash flows, because there is no actual cash outflow (Brigham, Gapenski, Ehrhardt, 1999). 6Estimated Earnings represent operating income after deducting incremental cost and depreciation. Given the applicable income tax rate, we will be able to compute the estimated operating income after taxes. In this particular case, no tax rate is given. 7Capital investment appraisal or capital budgeting is primarily concerned with incremental cash flows therefore depreciation should be added back to arrive at the projected cash flow from operations, because there is no actual cash outflow for depreciation (Brigham, et al, 1999). 8Estimated cash flow from Operations after adding-back depreciation charges. 9Increased salvage value also increases the cash flow during the year. 10 Unwinding of working capital, (2,500,000 + 800,000) increased cash flow by 3,300,000 on the 6th year. 11The total projected cash flow is the net cash flow after taking up all the increases and decreases on the cash flow from operations. 12The present value rate is the discount rate, (1/ (1+k) n, where k is the cost of capital, n is the time or year, the cash flow occurred. 3The discounted cash flows are the resulting cash flows after applying the cost of capital which is 14% or , projected cash flow during the year/ (1.14)t, where t represents the time or nth year, 1 is constant, and .14 or 14% is Tower’s cost of capital. To illustrate: Discounted Cash Flow for the first year is computed as: 2,890,000.00/ (1.14)1. For the second year, it is, 6,370,000.00/ (1.14)2, and so on until the sixth year. We will use the discounted cash flows in calculating the discounted payback period and the profitability index or PI (Gapenski, et al, 1999). APPLIED CAPITAL APPRAISAL TECHNIQUES 1. Regular Payback Period: 3.93 years 2. Discounted Payback Period: More than 6 years 3. Net Present Value (NPV): ($496,029) 4. Internal Rate of Return (IRR): 13% 5. Profitability Index (PI): .98 DISCUSSION AND EVALUATION Regular Payback Method. This method of appraising investment tells the number of operating years needed to recover the initial investment or cash outlay. It is the number of years required until the accumulated cash inflows will equal to the amount of the initial investment. The exact payback period is computed using the formula: Payback = Year before full recovery + (Unrecovered Cost at the start of Year/Cash Flow during the Year). If the capital is recovered within the shortest possible time, then this is good for the company (Brigham et al 1999). If the payback period is less than the companys required payback period for the investment, the proposal is accepted, otherwise it is rejected. However, this method does not consider significant cash flows or profit after the payback period. Therefore, this could not be a sound basis for deciding on the profitability of the investment (Bucklery 1996). For Towers, it will take 3 years before full recovery of proposed investment, total accumulated inflows for the period, is 19,110,000 ( 2,890,000+6,370,000+9,850,000). The total cash investment is the sum of the cost of the improvements and the beginning working capital, (26,000,000.00 + 3,300,000.00), or 29,300,000.00 therefore the unrecovered cost at the beginning of the fourth year is, (29,300,000-19,110,000) or 10,190,000. Cash flow on the fourth year is, 11,010,000.00. So the payback period is, 3/ (10,190,000/11,010,000) or 3.93 years. Discounted Payback Method. This method is a variant of the regular payback period, wherein the expected cash flows are discounted by the cost of capital, which is 14% for Towers. The discounted payback period tells us the number of years to recover the investment from discounted net cash flows. On the first page, the total discounted or present value of inflows for six year period is 28,803,971.00 as against the total investment of $29,500,000. The unrecovered cost is $496,029 or 1.7% of capital. This shows that with the proposed investment, Towers would not be able to recover the cost of their capital even until the end of six years. The Net Present Value Method. The net present value is considered as a reliable method of appraising capital because the cost of capital is considered for every cash flow by computing for the corresponding present values. The net present value is the sum of the present value of all cash flows less the present values of all cash outlays (Seitz, Ellison 2005). An NPV of zero tells us that the cash flows will cover the invested capital, and the cost of that capital, which is this scenario is, 14%. If the NPV is positive, then shareholder’s wealth is increased by the amount of the NPV. It is computed by finding the present value of the cash flows discounted by the cost of capital, and subtracting total discounted cash flows from the capital outlay. The discounted cash flows are presented on the first page. Simply subtract all the discounted cash flows from the initial cash outlay of (29,500,000) to get the NPV. Note that it is easier to find the NPV by using a financial calculator or by using Excel. The equation for NPV is: NPV=CF0+ [CF1/(1+k)1+ CF2/(1+k)2...+CF6/ /(1+k)6] where, CF0 is the total initial cash outlay for this proposed project is $29,500,000. TOWERS Plc has a negative NPV of $(496,029.00) (computed using Excel). A project with a positive NPV is accepted, while a negative NPV is rejected (Brigham et al 1999). Internal Rate of Return. IRR is the discount rate wherein which the present value of all project’s cash inflows would equal to the project’s capital investment cost. The discount rate that will bring the NPV to zero is the IRR. It is best to compute IRR using a financial calculator or Excel (Brigham 1996). If the IRR exceeds the cost of capital, the project is accepted, if not, it is rejected. According to Van Horne, “accepting a project with an internal rate of return higher than the cost of capital should result in an increase in the market price of the stock (1995, p.151).” Using Excel to compute for IRR, Tower’s IRR is 13%, which is less than its cost of capital. This means that only the initial investment and the cost of capital would be covered by all the cash flows with the proposed project, nothing will accrue to the shareholders. Profitability Index (PI). The profitability index is the ratio of the present value of benefits against the present value of the investment. If PI is 1.0, present value of inflows exceeds the present value of outflows, so the proposal is desirable. It measures “the wealth, or relative profit per dollar of initial outlay (Seitz, Ellison, 2005 pp. 184-185).” For Tower’s, PI would be 28,102,217.05/29,500,000.00, is .98 or only 98% of the capital and its cost would be covered by the future inflows , which means that the cost of the investment is higher than the benefit offered by the proposed project. RECOMMENDATION: Five capital appraisal techniques are presented for Towers with the given financial scenario. They are: (1) payback, (2) discounted payback (3) net present value (NPV), (4) internal rate of return (IRR), and (5) profitability index (PI). The use of these techniques in any industry, including the marine industry, helps weigh down opportunities against calculated future risks. Among the techniques used, only the simple payback method is positive, but the cost of money and the time value of money were not considered in the computation. The discounted payback method showed that investment cost will not be fully recovered during the useful life of the project. The NPV is negative which means the project should be rejected. Likewise, the project’s IRR does not exceed the cost of capital, it should be rejected. And, the PI also suggested that the project should be rejected. For the greatest wealth in a given set of conditions and opportunities, present value of projected benefits should exceed present value of capital outlay. If management should decide based on the result of these capital appraisal techniques, most likely, the proposed project would be rejected. It would be better for Towers then to invest their money in a project that would increase shareholders wealth rather just having enough to pay for the capital invested and for the cost of capital. However, Tower’s management may need to consider other factors before deciding whether to accept or reject the project if they have to maximise on wealth. Based on the computations presented, the margin between the decision to accept or reject the project is thin. It could be advantageous for Towers to perform a SWOT analysis and consider all internal and external forces that might have impact on the proposed project. Prevailing business conditions may invalidate any positive or negative financial appraisal. If we change the scenario and reduce the cost of capital to 13.5%, given the above scenario, all appraisals will be positive, and would led to acceptance of the project. Some opportunities maybe lost when management decide to reject investments which may increase the wealth of all stakeholders. One of the reasons that may lead to a reject decision is the application of high capital cost or interest, as a shield for the perceived riskiness of a particular project (Drury, et al 1997). Bibliography Brigham, E.F., Gapenski, L.C., Ehrhardt, M. C., 1999, Financial Management Theory and Practice Prentice Hall (UK) Ltd. Bucklery, A., 1996, International Capital Budgeting, 9th edn. Harcourt Asia Pte Ltd., India. Drury,C., Tayles, M., 1997”Misapplication of Capital Appraisal Technique” Management Decision. 5th August, 2009. http://www.oppapers.com/essays. Dykstra, D.L., 2005, Commercial Management in Shipping ,viewed 12th August, 2009. http://www.nauticalmind.com/Commercial-Management-in-Shipping-pr-69925.html. Seitz, N., Ellison, M., 2005 Capital Budgeting and Long –Term Financing Decisions, 4th edn., South- Western, Thomson: 2005. Van Horne, James C. 1995 Financial Management and Policy, 10th edn., Prentice Hall, Singapore. Read More