Coffee Manufacturing Company - Case Study Example

Introduction: The purpose of this report is to examine the current projection of sales of the New Home Grinder Cappuccino Machine for the purpose ofcapital budgeting in Coffee Manufacturing Company (CMC) and assess the relevant cash flow in terms of forthcoming profitability, financial stability and the potential liquidity risk of New Home Grinder Machine. Definition of the problem: On analysis, the primary problem with the projection of sales for the New Home Grinder Cappuccino Machine is that the overall fixed expenditure for this project was too high, including the test marketing costs, maintenance expenditures, wage costs and the working capital. To illustrate our finding, the result of the calculation illustrates that the cash flow for the beginning of the first four years of the sales of the New Home Machine projection are correlatively negative ranging from -146.35 to -273.0. In this sense, company may tend to make a loss for the earlier stage of this new projection and spend more money on the promotion of this new project and test marketing cost and so on due to the new project having low reputation, credibility and lack of competition as it is a new entrant within the industry. Problem statement Capital budgeting expenditure is usually of very high value; therefore, the management must undertake a careful analysis before resolving to put money in such projects. This is because, if decisions are made without careful analysis, heavy losses can be incurred or else the management can abandon a very profitable project. As such, this project will involve extensive analysis using techniques such as IRR, NPV and PBP. Objective: The objective of this capital analysis is to find out whether the management of Coffee Manufacturing Company (CMC) should adopt Home Grinder Cappuccino Machine or abandon it altogether. The decision as to whether to adopt the machine or abandon it will depend on the outcome of different capital budgeting methods including payback method, Net Present Values, and Internal Rate of Return. The analysis will ensure that the management adopts the projects only when there is an assurance that it will be of substantial economic benefit and abandon it if investing in it will not have any economic relevance. Method: The analysis will involve a variety of capital budgeting techniques such as Net Present values (NPV), Internal Rate of Return (IRR) and Pay back method. To establish the present values, a discount rate, which in this case is the opportunity cost of capital, is used. This opportunity cost is the minimum return that the organization would expect to earn from the project. Internal Rate of Return (IRR) is the discounted rate that equates cost of the investment with the present value of expected future cash flows. This is determined as follows: Pay back method is the number of years that a project takes to pay back its initial cash outlay. This is computed as follows: PBP=Initial Investment Annual cash flow A variety of methods are used rather than relying on a single method so the decision could be reached from different perspectives. In regards to NPV, the project will be considered viable if it generates positive cash flows. Key Finding: Moreover, the process of capital budgeting plays a vital role to assist a financial manager to assess and select appropriate capital expenditure for a long term investment in order to maximize the wealth of a firm. Under this circumstance, the use of “Net Present Value (NPV)”, the “Internal Rate of Return (IRR)” and “Payback Periods” are of mutual independence, which can be applied to analyse proposed investment decisions and evaluate the resulting impact on the firm value. To sum up, the four findings we concluded upon our calculation were: 1. The results of the finding illustrates that the cash flows from 1 year to 4th year average poor and are correspondingly negative. However, the net cash flows are increasing since 5th year, although it is negative in 6th year, which probably due to the economic downward cause the financial instable. 2. According to the concept of net present value, the project is only being accepted if the value of NPV greater than zero. In other words, the firm will thus gain a return greater than its cost of capital and thus enhance its wealth. In our case, the project for the “New Home Grinder Cappuccino Machine” would be rejected due to the NPV being correspondingly negative (-1435.8). 3. When the IRR is used to make accept or reject decisions regarding a proposed investment decision, the project will proceed if the value of IRR is equal to or greater than the cost of capital. Adopting this to our case, because the value of IRR is (-0.69944) which is less than the cost capital (0.15), as a result the project would not be accepted. 4. Firms often use payback period as its decision criterion for the proceeding of a new project, as the notion of payback period could be viewed as a measure of risk exposure. In this sense, the shorter the payback period will lead to a lower level of risk exposure to a firm. According to our calculation, the payback period is approximately 6 years whereas there is only a 10 years useful life for the new project. Therefore, the payback period should not proceed. Conclusion: In summary, the project for “New Home Grinder Cappuccino Machine” would be rejected as the company might tend to make a loss if they invest this project. Data illustrated the value of net cash flow for the first four years are negative, which indicates company is making losses at the beginning of this project. However, in the long run, the overall net cash flow increases gradually after the 5th year, the total positive value of net cash flow is almost able to cover the initial cost, although the 6th year’s net cash flow is showing negative again, maybe due to the ensuing global economic crisis and the new project still being a little unstable, thus affecting new cash flow. Recommendations: To recommended, the company may need to allow more available funds for the new investment of “New Home Grinder Cappuccino Machine”, this is because the firm might need to outlay a fair amount of expense on items such as advertising costs, operating cost and so on at the beginning of the first few years as the investment of the new project. As a result the product is not expected to break-even for the beginning stages of the project for the company. Other factors that can be considered include the following: The management should consider the availability of funds for investment. In this regards, the management should consider whether it has adequate funds to implement the project without many obstacles. There are a variety of sources of finance that can be considered including loans, trading in, and floating of shares among others. In addition, the management should consider whether the firm has enough personnel with relevant skills to operate the equipment that is to be purchased. These personnel should also possess the relevant technical skills to run the equipment. This consideration is very crucial; because competent personnel will ensure that the project is implemented successfully and hence increasing the returns from the project (Gitman, 2006). Another very important factor that the management should pay attention to is government regulation. In each country, there are relevant laws set by the government, which if not followed can lead to heavy penalties. These include licensing requirement and payments made before a project is embarked on. Furthermore, if the government has set laws prohibiting engagement into such a project, it would be prudent to look for an alternative location to set up the project or ditch it altogether (Gitman, 2006). Finally, the management should consider the political temperatures in the country at the time of investment. This is very important because political instability can lead to destabilization of the investment environment in the country, hence leading to heavy losses. A specific example to consider here is looming national elections, which could lead to political divisions and hence causing flare ups - in such a situation, the management should consider postponing or abandoning the project (Gitman, 2006). Reference: Gitman, L.J., 2006. Corporate Finance and Investment decision Strategies. New York: Richard Pike. Read More