Capital Budgeting Decision for Radiant Products - Essay Example

Radiant Products laundry limited: Capital Budgeting decision Submitted by: 3rd May INTRODUCTION Radiant Products laundry limited is one of the best producers of detergents. It produces traditional and concentrated powder detergents for its consumers. Radiant is the profitable company which is considering expanding its operations. It is considering the launch of its new product line of liquid detergent. The new product will be called as Dynamo. This liquid detergent is the result of extensive research work by the company. Although the new liquid detergent seems to be profitable venture, the company wants to be sure that it invests its money for the greater good. The company held a meeting to discuss the launch of its new product and the top management discussed in detail about the cash flow analysis and projections of the liquid detergent. FINANCIAL ANALYSIS OF THE NEW VENTURE The Chief Financial Officer, Mr. Mc Donald presented a report in a meeting which included the cash flow projections for the new project. He was planning to purchase specialized equipment and production facilities from Donnalley limited. Mr. Gasper, the production manager, inquired the CFO that why wasn’t he purchasing the equipment from Danforth limited. Being the financial analyst, I will analyze the purchase of equipment and facilities from Donnalley as well as Danforth limited if the company was planning to go with the project. BUYING EQUIPMENT AND FACILITIES FROM DONNALLEY LIMITED If the company will buy specialized equipment from Donnalley limited, then it is expected to have increased net cash flows for the project. For the first four years, company will be able to get increased cash flows of $580000. While for the next three years, company is hopeful to receive higher cash flows of $650000. However, the company will get net cash flows of $550000 for the remaining four years of the project. There will be reducing depreciation on the specialized equipments of the company which are shown in table 1. The Radiant limited will experience loss in sales revenue from the existing product lines during the term of the project. The EBIT and NOPAT are calculated for each year in the table 1. Following are the formulae for the calculations of EBIT, NOPAT and free cash flows. EBIT= Increase in net cash flows - depreciation –lost sales NOPAT= EBIT+ Taxes Table 1 also shows the free cash flows calculated for the ten years of the project. Free cash flows is calculated as: Free cash flows= NOPAT +Depreciation + Increase in net operating working capital In the fifth year, there was a need to purchase additional production facilities to meet up the growing demand of the detergents. The company will invest $5000000 to continue operations and production of detergents. The terminal cash flows are also calculated to come up with the free cash flows of the last year of the project. Tax on capital gains =Book value * tax rate = [2000000- (Total depreciation expense of ten years)] * 0.3 =16.949 Cash flows from sale of an asset = 80000 -16949 =63051 Terminal cash flows = 322264 + 63051 =385315 Annual Cashflows year 1 2 3 4 5 6 7 8 9 10 Increase in NCF 580 580 580 580 650 650 650 550 550 550 Dep 600 420 294 205.8 144.06 100.842 70.5894 49.413 34.589 24.212 Lost sale 70 70 70 70 110 110 110 100 100 100 EBIT -90 90 216 304.2 395.94 439.158 469.411 400.59 415.41 425.79 Tax -27 27 64.8 91.26 118.782 131.747 140.823 120.18 124.62 127.74 NOPAT -63 63 151.2 212.94 277.158 307.411 328.587 280.41 290.79 298.05 Dep 600 420 294 205.8 144.06 100.842 70.5894 49.413 34.589 24.212   537 483 445.2 418.74 421.218 408.253 399.177 329.82 325.38 322.26 NOWC -16 0 0 0 -14 0 0 20 0 0 FCF 521 483 445.2 418.74 407.218 408.253 399.177 349.82 325.38 322.26 New plant & facility         5000          63.05 (sales)   521 483 445.2 418.74 -4592.8 408.253 399.177 349.82 325.38 385210 Table 1 shows the free cash flows of the new project if the company purchases the specialized equipment and facilities from Donnalley limited. BUYING EQUIPMENT AND FACILITIES FROM DANFORTH LIMITED Let us suppose that the company can also purchase the plant, equipment and facilities from Danforth limited for launching a new project. The company will be required to purchase assets worth of 150000 for undertaking this project. There will be an increase in net operating working capital of $100000 after the purchase of facilities from Danforth limited. The company will be able to save $20000 more each year in the net cash flows as compared to the purchase of facilities from Donnalley limited. The company will use MACRS depreciation model for calculating the depreciation expenses of the specialized equipment. The calculation of Free cash flows has been shown in table 2. At the end of the usage period of equipment, company will be able to sell it at $50000. There will be a tax savings on loss and the terminal cash flows will be calculated as: Terminal cash flows : =free cash flow+ sale of asset =378.5+62 =440.5 The cash flows of the project are shown below: TABLE 2: Annual Cash flows year 1 2 3 4 5 6 7 8 9 10 Increase in NCF 600 600 600 600 670 670 670 570 570 570 Dep 300 480 285 180 165 300 480 285 180 165 Lost sale 70 70 70 70 110 110 110 100 100 100 Ebit 230 50 245 350 395 260 80 185 290 305 Tax 69 15 73.5 105 118.5 78 24 55.5 87 91.5 NOPAT 161 35 172 245 276.5 182 56 129.5 203 214 Dep 300 480 285 180 165 300 480 285 180 165   461 515 457 425 441.5 482 536 414.5 383 379 NOWC -20 0 0 0 -14 0 0 20 0 0 FCF 441 515 457 425 427.5 482 536 434.5 383 379                         441 515 457 425 427.5 482 536 434.5 383 379 New plant, facility         1500             441 515 457 425 -1073 482 536 434.5 383 379 Sale of assest         62             441 515 457 425 -1011 482 536 434.5 383 379 If we just compare on the basis on initial investment, then Radiant limited should purchase of equipment from Danforth limited. The initial investment in the assets of Donnalley limited will cost $2000000 whereas the initial investment in Danforth assets will be $1500000. COMPARISON ON THE BASIS OF SEVERAL OTHER MEASURES Net Present Value (NPV) is the sum of present values of the cash inflows and outflows of the project. When the radiant limited purchases assets from Donnalley limited, its NPV will be -2502. However, when the company buys its equipment from Danforth limited, its NPV will be 168$. When we compare the two options on the basis of NPV’s, the second option seems better as its NPV is a positive number. Internal Rate of Return (IRR) is the rate of return to measure the return on investments made by the company. The IRR of the Radiant is 15% when the company uses equipment from Danforth limited. This IRR is greater than the Weighted Average Cost of Capital (WACC) which is 12%. Thus the company should choose second option on the basis of IRR. Modified Internal Rate of Return (MIRR) is the better version of IRR which is used to assess the attractiveness of investments made by the company. The MIRR of Radiant limited with the first option is 4% which is quite lower than WACC. However, the MIRR for the second option (purchase from Danforth limited) is 13% which is quite higher than WACC. Thus on the basis of MIRR, company should purchase equipment from Danforth. The payback period is quite useful to find out the period when the investment made will return back to the company. The Radiant Company will not be able to get back its investment due to heavy expenditures in the purchase of assets, equipment and facilities from Donnalley limied. However, the Radiant company will be able to get back its investment in 3.44 years if it purchases its equipment and facilities from Danforth limited. In terms of payback period, Radiant should prefer second option for the launch of its new detergent. The Profitability Index (PI) measures the extent of profits from investments made in the ventures. The PI of Radiant is -0.19$ when the company chooses the first option. However, the profitability index of Radiant is 1.11$ for the purchase of equipment and facilities from Danforth limited. The PI for second option is comparatively higher; therefore, company should go with it for the purchase of assets. SENSITIVITY ANALYSIS: Being the financial analyst, I am conducting a sensitivity analysis with respect to changes in free cash flows and weighted average cost of capital. I have decided to check the sensitivity of two variables with respect to changes in 20% from the mean of NPV. Below is the table which shows the free cash flows of project. The cash flows shows the deviation from 20% of the mean value when the company purchases equipment from Donnalley limited. 0 1 2 3 4 5 6 7 8 9 10 0% -2100 521 483 445.2 419 -4593 408.3 399.2 350 325.3766 385.3151 20% -2100 625.2 579.6 534.2 502 -5511 489.9 479 420 390.452 449.7679 -20% -2100 416.8 386.4 356.2 335 -3674 326.6 319.3 280 260.3013 320.8624 Below is the table which shows the free cash flows of project. These cash flows are the deviation from 20% of the mean value when the company buys the equipment from Danforth limited. The sensitivity analysis of the new project shows that the company is showing greater impact on NPV when we are deviating the WACC and FCF from mean while purchasing equipment from Donnalley limited. While we deviate 20% from the mean value, there still remain the positive NPV when we are purchasing from Danforth NPV. The sensitivity analysis from Danforth purchases shows better results than Donnalley. Sensitivity Analysis Donnalley NPV Danforth NPV Deviation from base WACC FCF WACC FCFF -20% ($2,588.00) ($2,418.15) $346.33 ($181.58) 0% ($2,502.76) ($2,502.76) $168.03 $168.03 20% ($2,423.28) ($2,587.37) $17.33 $517.64 Below is the graph which shows the sensitivity analysis of Donnalley limited. Below is the graph which shows the sensitivity analysis of Danforth limited. According to sensitivity analysis, radiant should purchase equipment from Danforth limited. Radiant limited will be happy if it gets its initial investment back as soon as possible. However, radiant energy will accept the minimum cash flows equal to its initial investment so that it continues to operate. The company will have to look at inflation in the future while considering its cash flows. Even if the inflation premium is 3% per annum, the company will be better off with the second option as it is operating at higher cash flows and has a positive NPV. CONCLUSION: The Radiant limited should continue to work on its new liquid detergent. However, it should purchase equipment and facilities from the Danforth limited so that it can be able to generate profits during the project. It will not be suitable for the company to buy equipment from Donnalley limited as it will increase its outflows and cash inflows will not be large enough to make it profitable. Bibliography Gunawan. (2005). Sensitivity analysis of dicrete stochastic systems. Biophysical journal , 2530-2540. Internal rate of return. (2012). Retrieved May Thursday, 2012, from Investopedia: http://www.investopedia.com/terms/i/irr.asp#axzz1tqFVVlM7 Modified Rate of return. (n.d.). Retrieved May Thursday, 2012, from Tech on the net: http://www.techonthenet.com/excel/formulas/mirr.php Payback period. (n.d.). Retrieved May Thursday, 2012, from Bized: http://www.bized.co.uk/virtual/bank/business/finance/investment/theories1.htm Pietersz, G. (n.d.). Net present value. Retrieved May Thursday, 2012, from Money terms: http://moneyterms.co.uk/npv/ Profitability index. (n.d.). Retrieved May Thursday, 2012, from Wolframalpha: http://www.wolframalpha.com/entities/calculators/profitability_index_calculator/mp/r9/g8/ Read More