Financial Decision Making and Risk - Coursework Example

Financial Decision Making and Risk 1. Background Your company, a medium size manufacturing company is investigating the possibility of replacing its current sub-assembly line with an automated assembly cell. The new assembly cell will consist of five new robots, each one costing £32,000, with associated gripping devices costing total of £65,000. The roller tracking plus the assembly fixtures, etc. will cost an additional £15,000. However, the new cell will replace the existing sub-assembly line which currently requires eight fitters at a cost of £18,500 per annum each. It is estimated that the reduction in scrap/rework will save ad additional £5,000 per year. The new assembly cell will require three call programmer/operators who will be 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. Your company’s cost of capital is currently 10%. As the Financial Director of your company, you are required to submit a detailed report to the Managing Director and your fellow Board members evaluating the proposed investment, fully justifying any recommendation you will make and identifying any potential problem areas and offering potential solutions. 2. Introduction “Investment appraisal is the process of assessing potential investment projects to see which ones are most viable (and profitable) for the firm.” (Samuels et al, 2000). This report is aimed at understanding whether investing into the automated assembly cell will be beneficial for the company. To analyse the benefits of the investment a number of different calculations including the payback period and sensitivity analysis has been made. These have been included in the next few sections along with the investment decisions based on the calculations. The study of the new robots cell will consist of the following calculation:- Cash flow forecasting Payback method Return On Investment (ROI) Net Present Value method (NPV) Discounted Payback Internal Rate of Return method (IRR) Sensitivity analysis Capital Back method 3. Cash-Flow Forecasting The Net Cash Flow is method of scoping the company cash expenses and earning. CASH-FLOW FORECASTING BENEFITS Year Year Year Year Year Year   0 1 2 3 4 5 8 fitters @ 18.5 K £ - 148 148 148 148 148 scrap / rework K £ - 5 5 5 5 5 5 robots scrap @ 1 K £ - - - - - 5 TOTAL BENEFITS - 153 153 153 153 158               COSTS             5 robots@ 32 K £ 160 - - - - - tooling ( 65 + 15 ) K £ 80 - - - - - 3 programmer @ 20 K £ - 60 60 60 60 60 TOTAL COSTS 240 60 60 60 60 60               NET CASH FLOW K £ (240) 93 93 93 93 98 4. Pay-Back Method Payback period is one of the simplest methods of investment appraisal. This method is generally beneficial for short-term projects and for projects where the returns are fixed and accurate. The most beneficial feature of this method is that it takes into account the liquidity of the project, which is useful for businesses to understand and concentrate on the cash flows of the company. Also this is a very simple method comparatively (Samuels et al, 2000). PAYBACK METHOD Year Cash-Flow Cumulative Cash-Flow 0 (240) (240) 1 93 (147) 2 93 (54) 3 93 39 2 ( 54/93 ) year = 2.58 years 4 93 132 5 98 230 Pay Back Period = 2.58 years 5. Return On Investment (ROI) The finance Return on Investment is used to express the ratio of the money gained on the investment relative to amount of money that has been invested. Return On Investment = average annual receipts x 100 total capital employed 1 Return On Investment = ( 93 + 93 + 93 + 93 + 98 ) / 5 x 100 240 1 Return on Investment (ROI) = 39.167% 6. Net Present Value (NPV) Net Present Value (NPV) is the most commonly used method and it utilizes the discounted cash flows to compute the returns from an investment. In this method, initially all the future cash flows that will be generated by the project are discounted to present value. This value is then reduced by the initial investment to arrive at the Net Present Value (NPV). NET PRESENT VALUE Year Cash flow Discount factor Percent value 0 (240) 1 (240) 1 93 0.9091 84.5463 2 93 0.8264 76.8552 3 93 0.7513 69.8709 4 93 0.683 63.519 5 98 0.6209 60.8482 NPV = 115.6396 Net Present Value = 115.6396 K £ 7. Discounted Payback Method Discounted payback method is similar to the payback period that has been calculated. In this method the time factor is taken into consideration and this allows provides a more accurate payback period. DICOUNTED PAYBACK METHOD Year Cash-Flow 10%   Cumulative 0 (240) 1 (240) (240) 1 93 0.9091 84.546 (155.454) 2 93 0.8264 76.855 (78.5985) 3 93 0.7513 69.871 (8.7276) 4 93 0.683 63.519 54.7914 5 98 0.6209 60.848 115.6396 Discounted Pay Back (Years) = 3.1374 Discounted Pay Back Period = 3.1374 Years 8. Internal Rate of Return Method (IRR) This method is based on trial and errors. To make decisions based on the IRR of a project – accept if the IRR is greater than the required rate of return and reject if the IRR is lesser than the required rate of return. Summary of calculation 1. Net Present Value at 10 % 115.6396 2. Net Present Value at 27% 1.7046 3. Net Present Value at 28% (3.0783) 4. Net Present Value at 29% (7.6908) 5. Net Present Value at 30% (12.152) IRR = (27 % + (1.7046 /(1.7046 –( 3.0783) ))) * (28%-27%) IRR = 27.356% 9. Sensitivity Analysis Sensitivity analysis is a way to predict the outcome of decisions if the situation is different from that predicted. ( + 20 %) ( - 20 %) CAPITAL 67.6396 163.6396 RESIDUAL VALUE 116.2605 115.0187 DURATION 164.9259 58.2064 ANNUAL RETURN 186.76752 44.51168 INTEREST RATE 98.0834 134.7148 10. Capital Back Method This method provides a clearer view of the number of years it would take to receive back the capital. This takes into consideration of the risk and flexibility of the project while calculating the period for the capital to be earned back. Ct = Cf + Cr Where;- Ct =Total cost of the investment. Cf =Cost of flexibility. Cr = Cost of risk. Net return 0 1 2 3 4 5 0 153 153 153 153 158 Cost of Flexibility Initial cost £ K On going cost £ K Robots 160 programmer 60 Annual cost 160/ 5 = 32 = 60 Total annual cost of flexibility = 32 + 60 = 92 Total initial risk = 65 + 15 = 80 Annual return to cover initial risk;- 0 61 61 61 61 66 Capital back = 1.31147541 year  CAPITAL BACK;- = 1.31147 years 11. Calculations Summary The annual net cash flow for the project was computed as £ 93 K for the first 4 years and £ 98 K for the fifth year. This indicated a pay back period of two and half years. Based on the net cash flow, the return on investment was found to be 39%. As the company’s cost of capital is not taken into account in the net cash flow, these values do not give a clear indication to the management about the profitability of the project. The net cash flow every year is discounted at the company’s cost of capital and the net present value is found to be £ 114.64 K. This is a positive return to the company, indicating that the project is profitable. Based on the present values, the discounted pay back period is calculated to be 3.1 years. In these methods, the risk is not taken into account, i.e., in case the cash flow varies, the effect on the returns is not considered. The internal rate of return is computed to arrive at the margin of safety. The internal rate is the maximum cost of capital that can be paid for the project without the company incurring any losses, i.e., the rate at which the net present value is zero. This value is found to be 27.5% which is a relatively high value, indicating that the project has a high margin of safety. In order to analyse the effect of the other costs involved, the sensitivity analysis was carried out and it was found that the residual value and the interest rate show comparatively lesser variations. 12. Other issue There are a number of cost cutting initiatives that can be undertaken by the management to ensure better returns from the project. These initiatives are discussed in this section. First and fore most, the management has to understand the fact that the skill set and competency of the employees have a direct impact on the cost of labour. The management has to carefully set periodic objectives to the employees to gradually increase the productivity rate. Bonus pay systems based on the performance of the employees can be implemented. This will motivate the employees to work efficiently. The assembly and other fixtures will incur higher set up costs. These set up costs have to be reduced by implementing effective production processes and workflow systems. The management should also implement effective quality process (Quality checks, inspections and maintenance activities) which will ensure that the products are of high quality. Proper maintenance of the equipment will reduce the capital decay and in turn increase the resale value of them. The resale value of the equipment has a direct impact on the returns from the project. The non-value added activities have to be reduced, in order to cut costs. The storage time, i.e., the period for which the product stays in the inventory, has to be reduced. In order to achieve this, Just – in – time production process can be adopted which will enable higher inventory savings. 13. Equity and Financing The company will also need to consider the various possible sources of finance. There are a number of choices for financing the project. The best suitable options to finance the project are discussed in this section. Ordinary and Preference Shares: This forms one of the best ways to finance the project. In this case the company will be able to raise funds from its investors to implement the automated assembly system. Financing through the ordinary shares will allow the company to raise enough capital and company has the option of investing the funds into buying the equipment without the issues of liquidity. The cost of capital under this method is the rate of dividend declared by the company and is normally paid out of the profits once completed and the start of operations of the project. Preference shares: This is a very beneficial mode of investing into the project. The company has the power to choose who invest into the project. Also the investors benefit from this as the returns are normally higher (Samuels, Wilkes and Brayshaw, 2000). Debentures and Medium Term Loans: Issuing debentures can also raise capital for the company. These generally carry a fixed rate of interest and are redeemable after a fixed period. This allows the company to utilise the funds and pay back the debentures to the investors after the fixed period. This allows the company sometime to earn back the money from the investment. Similarly even the medium term loans allows the company with some time to earn back the monies from the investments and pay back over a period of time. Bank Loans: This is one of the best sources of finance for the company and will prove to be most beneficial. Similar to the medium term loans these loans are required to be paid back over a period of time. These loans have a well defined interest, repayment schedules, execution of agreement and also possible fore closures. After analysing the various finance options, it can be concluded that Bank loan is the most suitable option for the company. This is mainly because the risk involved with the bank loan is comparatively lesser and the company will also receive many other benefits like bank over drafts, a current account and other benefits. Bibliography Samuels, J. M., Wilkes, F. M. and Brayshaw, R. E., 2000, Management of Company Finance, 6th edn, Thomson Learning, London Read More