Capital Budgeting Decisions - Case Study Example

Capital Budgeting Decisions Submitted by XXXXXX Number: XXXXXX XXXXXXX of XXXXXXX XXXXXXXX XXXXXXX Date of Submission: 22 – 11 – 2010 Number of Words: (Excluding Bibliography) Part 1: Alpha Plc is considering an investment on an open – cast coal mine in South Wales. This report aims at analyzing the cash flows generated by the project and determining the profitability of the coal mine. Investment appraisal techniques are applied to determine the value created by the project. The methods chosen for this appraisal are Net Present Value (NPV) and Internal Rate of Return (IRR). Cash Flows generated by the Project: In order to evaluate the profitability of the project, the cash flows generated by the coal mine are determined using the estimates provided. The initial investment is computed as follows: Purchase of coal – mine = £ 2.75 million Cost of Equipment and Vehicles = £ 13.75 million Total Initial Investment (Year 0) = £ 16.50 million As the survey expenses of £ 0.22 million have already been incurred by the company, they are irrelevant in the decision making process and are considered as sunk costs (Emery, 2007). The key concepts applied in preparing the cash flow statement are as follows: 1. As existing work force is used for the project, the wages and salaries are incurred by the company irrespective of the decision taken. However in the first year, as the employees will be idle if the project does not proceed, this cash flow has to be taken into account as an opportunity cost. 2. The working capital of £ 0.55 million is invested in the first year (which is included in the wages and salaries). Working capital recovery is included in the fourth year. 3. The depreciation of equipment and vehicles are not cash flows and hence they are not taken into account. However the equipment and vehicles can be sold for £ 2.75 million in fourth year and is considered as a cash inflow. 4. Only one third of the head office expenses are incurred directly as a result of the coal mine project. Hence only £ 0.22 million is considered as the cash flow related to head office expenses. 5. Of the total £ 0.44 million incurred in survey expenses, £ 0.22 million is sunk cost and hence only the remaining £ 0.22 million is considered as cash outflow. 6. Interest charges, selling & distribution costs and the materials & consumables are assumed to be incurred in the same year and are taken as direct cash outflows. 7. In the fourth year, the company has to spend £ 0.44 million in clean – up. The cash flow statement for the four years is prepared based on these guidelines and is presented in appendix 1. Net Present Value: Net Present Value utilizes the discounted cash flows and computes the total worth of the project to the company. The cash flow estimates for the life of the project are discounted to present values using the cost of capital and the net sum of the cash flows (including any outflows) provides the Net Present Value of the project (Gillespie, Lewis, & Hamilton, 1997). It indicates that the project will increase the worth of the company by a value equivalent to the NPV. The projects with positive NPV are accepted. The cost of capital of the company is 12 %. The net present value of the project is estimated as shown in appendix 2. From the calculations, the net present value (NPV) of the project is found to be £ 2.33 million. Internal Rate of Return: The internal rate of return is used to compute a maximum discount rate that can be applied to the project without incurring any losses and gives an indication of the margin of safety of the project (Emery, 2007). IRR calculation works on trial and error basis. Initially the NPV for an assumed rate is determined and based on this value; another rate is selected so that the new NPV approaches closer to zero (Samuels, Wilkes, & Brayshaw, 2000). Based on these two values, the IRR can be computed using the cross-multiplication rule. The IRR calculations (see appendix 3) indicate that the internal rate of return for the project is 18.05 %. Selection Approach - Investment Appraisal Methods: There are many methods available for investment appraisal and each has its own merits and demerits. The reasons for choosing the Net Present Value (NPV) and Internal Rate of Return (IRR) in this coal mine project are explained in the following section. Net Present Value (NPV): Net present value method is one of the most commonly used methods. This method takes into account the time value of money and throws light on the possible profits the company would earn by undertaking a certain project. NPV is generally used to compare projects on the basis of factors like cost benefits, earnings, etc. The decisions it provides are very simple and easily understandable (Samuels, Wilkes, & Brayshaw, 2000). Internal Rate of Return (IRR): This method allows assessment of risks involved in every proposal and has an intuitive appeal. IRR adopts the usage of cash flows instead of the earnings and accounts for the time value for money. Recommendation: It is evident that the NPV of the project is positive and significant (£ 2.33 million). Hence NPV suggests that the project should be taken up by Alpha Plc. Moreover, the IRR value for the project is 18.05 % which is significantly higher than the cost of capital of the company. Hence there is lesser risk for the project to incur any losses. Hence the company should proceed with the purchase of the coal – mine from the British government. Part 2: Any investment decision in an organization has to be financially justified so that it is in the best interest of everyone. It is essential then, that the management makes informed decisions when considering every investment proposal, as these decisions may not be easily reversible, involve large sums of money and are generally based on predictions. Hence, it is essential that the management is aware of any potential issues in the investment appraisal process and the cost of capital used. The risks involved are also important in the decision making process (Samuels, Wilkes, & Brayshaw, 2000). These issues are addressed in the following section. Issues in Investment Appraisal: The methods used in the case of Alpha plc, namely Net Present Value (NPV) and Internal Rate of Return (IRR) have some limitations. It is essential that these limitations are taken into account before the decision is made. Though NPV is the widely used method, it does not take inflation into account in its calculations. If there are huge deflections in the inflation rates during the period of the project (4 years), the NPV values estimated are meaningless. Though NPV accounts for the time value of money, it does not take into account the time of the year in which the cash flow occurred (Constantini, 2006). For instance, an inflow in the beginning and the end of the year are treated as equal. This can have a great impact on the NPV computed and the actual value of the project might be totally different. Moreover the NPV method does not take the profitability of a project, i.e., the profits relative to the initial investment. In other words, NPV does not offer comparison on the initial outlay and the income arising from that outlay (Gotze, Northcott and Schuster, 2007). The major demerit in the case of IRR is that a particular investment can have more than one IRR value. Varying IRR values may be misleading and might lead to unfavourable decisions. The method also involves complex calculations as this is a trial and error method (Connolly, 2006). When two or more projects have very high values, the IRR method does not help in the final decision (Lefly, 1997). Though it gives an indication of the minimum allowable value for the cost of capital, it does not provide any useful information on the volatility of the cost of capital. Cost of Capital: The main factor, apart from the cash flow estimations, determining the approval of a project is the cost of capital. The cost of capital differs based on the capital structure of a company. It also depends on the cost of debt and cost of equity for the company. The value of cost of capital is usually determined using the WACC (Weighted Average Cost of Capital) method, which accounts for the costs of equity and debt, and also the capital structure. The cost of equity is dependent on the market risk free rate, usually the treasury yields, the expected risk premium and the beta value of the company. Due to the volatile nature of the financial market, these values vary significantly over time. Moreover, highly leveraged companies operating on a large scale tend to have a dynamic capital structure (Kruschwitz and Loeffler, 2005). The proportion of debt and equity varies significantly over time in these companies. This leads to varying cost of capital. It is evident that the cost of capital in most cases is volatile and is likely to change during the life of the project. This can affect the returns and the Net Present Value computed during the project start up. In the case of Alpha Plc, the life of the project is expected to be 4 years and the cost of capital (12 %) is assumed to be constant throughout this period. The management needs to carefully analyze its capital structure, account for variation or any other long term plans before finalizing the cost of capital. Risks: There are a number of risks involved in the investment for Alpha Plc. These factors are explained in the following section. Cost of Capital: As explained in the previous section, the cost of capital is very complicated and requires careful examination before making a final decision in investment appraisal. In the case of Alpha Plc, the IRR (Internal Rate of Return) is computed to be 18.05 % (Drury, 2005). The management of the company needs to ensure that the cost of capital will not go above the IRR. Inflation: The NPV and IRR calculations do not take inflation into account. During the lifetime of the project, it is likely that the inflation levels vary significantly causing fluctuations in the value of money. This will affect the NPV of the project. Hence inflation has to be accounted before finalizing the decision (Fisher and Martin, 1994). Cash Flow Projections: The NPV and IRR calculations depend on the cash flow projections for the lifetime of the project. It is imperative to note that these are estimates and in actual scenario, the conditions may pan out differently. The management needs to conduct sensitivity analysis to identify the minimum level of cash flow required to avoid any losses. This will give a clear indication of the potential risks involved in the project. Summary: Thus the investment appraisal process (NPV and IRR) indicate that the project is profitable to the company and should be accepted. The rationale behind for the selection of these methods is also explained. Finally the various issues related to the investment management process, the cost of capital and the risks involved are also explained to enable the management to make an informed decision. Bibliography Connolly, M., 2006, International Business Finance, Routledge Publications, December 2006 Constantini, P., 2006, Cash Return on Capital Invested, 2nd edn, Butterworth – Heinemann Publishers, Boston, Massachusetts Drury, C., 2005, Management Accounting for Business, 3rd edn., Thomson Learning, London Emery, R. F. (2007). Corporate Financial Management (3rd Edition ed.). Prentice Hall. Fisher, J.D. and Martin, R.S., 1994, Investment Analysis for Appraisers, 1st edn, Dearbon Real Estate Education, London Gillespie, I., Lewis, R., & Hamilton, K. (1997). Principles of Financial Accounting. Europe: Prentice Hall. Gotze, U., Northcott, D. and Schuster, P., 2007, Investment Appraisal: Methods and Models, 1st edn, Springer Publications, London Kruschwitz, L. and Loeffler, A., 2005, Discounted Cash Flow: A Theory of the Valuation of Firms, 2nd edn, Wiley Publishers, New Jersey Lefly, F., 1997, ‘Modified Internal Rate of Return: Will it replace IRR?’, Management Accounting, Vol. 75, No. 1, January 1997 Samuels, J. M., Wilkes, F. M. and Brayshaw, R. E., 2000, Management of Company Finance, 6th edn, Thomson Learning, London Appendix 1 – Cash Flow Statement Cash flow statement for the four years is prepared based on the income and expense estimates. Only marginal or incremental cash flow arising due to the project is taken into consideration. Cash Flow Statement (in £ million) Year Year 1 Year 2 Year 3 Year 4 Sales 10.34 10.78 9.35 6.93 Equipment & Vehicles - - - 2.75 Working Capital Recovery - - - 0.55 Total Cash Inflow 10.34 10.78 9.35 10.23 Wages & Salaries 2.53 - - - Selling & Distribution 1.43 1.32 1.65 0.66 Materials & Consumables 0.33 0.44 0.44 0.22 Head Office Expenses 0.22 0.22 0.22 0.22 Survey Costs 0.22 - - - Interest Charges 1.32 1.32 1.32 1.32 Clean-up - - - 0.44 Total Cash Outflow 6.05 3.3 3.63 2.42 Net Cash Flow 4.29 7.48 5.72 7.81 Appendix 2 – Net Present Value The net present value is computed as: PV of future cash flows = (t=1ton) Ct/(1+r)t where Ct is the cash flow generated in period t, r is the discount rate used and n is the number of years. Net Present Value (in £ million) Year Cash Flow Discount Factor Present Value Year 0 -16.50 1.0000 (16.50) Year 1 4.29 0.8929 3.83 Year 2 7.48 0.7972 5.96 Year 3 5.72 0.7118 4.07 Year 4 7.81 0.6355 4.96 Net Present Value 2.33 Appendix 3 – Internal Rate of Return IRR indicates the rate of return at which the NPV of the project becomes zero, i.e, the discount rate at which the project yields neither gains nor losses. Internal Rate of Return (in £ million) Year Net Cash Flow Year 0 (16.50) Year 1 4.29 Year 2 7.48 Year 3 5.72 Year 4 7.81 IRR 18.05% Read More