Investment Appraisal - Report Example

Investment Appraisal Evaluation of the Investment Opportunities Capital budgeting is the process by which we conduct appraisal of strategic projects which have long term implications. It involves incremental analysis of the projects which means that we analyze what will happen if the company undertakes the project and what will happen in the case if the project is not taken. We will start our analysis by presenting the net income statement of Penta Ltd. in case it does not pursue any of the projects. It is important to mention that all the figures will be converted to nominal terms since we have a nominal discount rate. The other way is also possible in which we can convert all the figures into real term and use a real discount rate. We have adjusted nominal rates by using the formula Nominal Rate = ((1 + Real interest rate) x (1 + inflation rate)) – 1 As we know that the expected inflation rate is 2 % while the real increase in sales and operating costs will be 1 %, if the firm does not pursue the project. Therefore by using the above formula we have found the nominal rate to be 3.02% annually. The sales and operating cost figures have been adjusted at an annual rate of 3.02%.   2010 2011 2012 2013 2014 2015 2016 Sales 8.00 8.24 8.49 8.75 9.01 9.28 9.56 Cost of Sales 3.84 3.96 4.08 4.20 4.33 4.46 4.59 Gross Operating Profit 4.16 4.29 4.42 4.55 4.69 4.83 4.97 Administration and Selling Costs 2.09 2.15 2.22 2.29 2.35 2.43 2.50 Depreciation Expense 0.89 0.89 0.89 0.89 0.89 0.89 0.89 EBIT 1.18 1.24 1.31 1.37 1.44 1.51 1.58 Interest paid 0.48 0.48 0.48 0.48 0.48 0.48 0.48 EBT 0.70 0.76 0.83 0.89 0.96 1.03 1.10 Less Tax 0.21 0.23 0.25 0.27 0.29 0.31 0.33 Net Profit 0.49 0.53 0.58 0.63 0.67 0.72 0.77 All the amounts are in million £ We can prepare the cash flow statements from the above income statement by adjusting for changes in net working capital and depreciation expense Cash Flow = Net Income + Depreciation Expense - Increase in net working capital We assume that the net working capital figure varys with the sales amount therefore based on our assumption, the changes is net working capital can be computed as follows   2010 2011 2012 2013 2014 2015 2016 Working Capital 0.50 0.52 0.53 0.55 0.56 0.58 0.60 Net Change in Working Capital 0.50 0.02 0.02 0.02 0.02 0.02 0.02 The forecasted cash flow statements without undertaking any of the projects will be 2011 2012 2013 2014 2015 2016 1.41 1.45 1.50 1.55 1.60 1.65 Investment Opportunity 1 – Build new factory abroad The life span of each of the projects is estimated to be five years starting from 2012 to 2016. Penta Ltd has paid £40,000 to buy the land. The total investment required for acquiring the land and the factory is £8million, for which 75% of the funds will be spent one year before the factory becomes operational (2011) and 25% in the following year (2012). This means that £6million will be invested in 2011 and £2million will be invested in 2012. Sales will by grow 30% per year over the first three years of operation in real terms so will adjust for the nominal rate using the formula. After the initial three years the growth rate will revert to 1% in real terms. Working capital will vary with sales for the initial three years and there will be no change afterwards. Cost of Sales will be 48% of sales in the year when the project is launched at a full scale. There will be a 6% reduction in the following year followed by 4% reduction in the subsequent years. Administration and Selling costs will increase by 10% a year in real terms until 2013 and will remain stable till the end of the project. We will convert all the real rates into nominal rates since we are assuming that the project has a nominal weighted average cost of capital. Therefore it is necessary to adjust for inflation factor before discounting the cash flows. Nominal Sales Growth = 32.6% Nominal increase in administrating and selling costs = 12.2% Projected Net Income Statement with the Project   2010 2011 2012 2013 2014 2015 2016 Sales 8.00 8.24 10.93 14.49 19.22 19.80 20.39 Cost of Sales 3.84 3.96 5.25 6.09 8.45 8.71 8.97 Gross Operating Profit 4.16 4.29 5.68 8.40 10.76 11.09 11.42 Administration and Selling Costs 2.09 2.15 2.42 2.71 2.76 2.82 2.88 Depreciation Expense 0.89 1.27 1.27 1.27 1.27 1.27 1.27 EBIT 1.18 0.86 2.00 4.42 6.73 7.00 7.27 Interest paid 0.48 0.80 0.80 0.80 0.80 0.80 0.80 EBT 0.70 0.06 1.20 3.62 5.93 6.20 6.47 Less Tax 0.21 0.02 0.36 1.09 1.78 1.86 1.94 Net Profit 0.49 0.04 0.84 2.54 4.15 4.34 4.53 The depreciation and interest expense are calculated as follows: Since the land and factory will cost at a total of £8million and land is acquired for £40000 which is not depreciable we assume all other equipments and materials are depreciable therefore £7.6million is depreciated over the lifetime of 20 years. The addition to depreciation will be 0.38 million per year. The new investment requires raising debt amounting to £4million which will have an annual interest expense of £0.32 million per year. Net Working Capital Statement   2010 2011 2012 2013 2014 2015 2016 Working Capital 0.50 0.52 0.68 0.91 0.91 0.91 0.91 Net Change in Working Capital 0.50 0.02 0.17 0.22 0.00 0.00 0.00 Cash Flow Statement for the Project The project will incur £6million in 2011 and £2million in 2012 so they will be deducted from the cash flows. 2011 2012 2013 2014 2015 2016 -4.70 -0.06 3.58 5.42 5.61 5.80 Incremental Cash flows from the project Incremental cash flows can be obtained by deducting the cash flows without undertaking the project which we calculated initially. 2011 2012 2013 2014 2015 2016 -6.11 -1.51 2.09 3.87 4.01 4.16 NPV of the Project: The marginal cost of capital will be 8.60% - .04% So we will use 8.56% as a discount rate. = -6.11 -1.51/(1+.0856)1+2.09/(1+.0856)2-3.87/(1+.0856)3-4.01/(1+.0856)4-4.16/(1+.0856)5 NPV = £2.70 Investment Opportunity 2 – Enter into the retail business It will require an initial Required of £5million in 2011; Sales will grow 22.5% from 2012 until 2015 in real terms, after which they will stabilize. Here we need to adjust real rate of growth to nominal growth. Working capital will increase in line with sales until 2015 and no change afterwards An increase in staffing will cause the labor costs to increase by 50 % in real terms only in 2012, which are 50% of the Cost of Sales, with no further increase afterwards. Material costs will increase in line with Sales which are 24% of the sales. A sample calculation for year 2012 is provided as below Cost of sales for 2011 = 3.96 50% of the sales is for labor = 1.98 It will increase by 53% in nominal terms = 1.98 x 1.53 =3.03 Material Costs = 24% of sales = 2.47 Total Cost of sales for 2012 = 3.03 + 2.47 = 5.50 The Administration and Selling costs as a percentage of Sales will increase by 2 percentage points due to increase in distribution costs The new assets will be depreciated over the lifetime of 20 years Depreciation expense = 5/20 = 0.25 million Additional interest expense on 2.5 million debt = 0.2 million Projected Net Income Statement with the Project   2010 2011 2012 2013 2014 2015 2016 Sales 8.00 8.24 10.30 12.87 16.08 20.09 20.70 Cost of Sales 3.84 3.96 5.50 6.18 7.01 8.04 8.25 Gross Operating Profit 4.16 4.29 4.80 6.69 9.07 12.05 12.45 Administration and Selling Costs 2.09 2.15 2.42 2.75 3.16 3.66 4.18 Depreciation Expense 0.89 1.14 1.14 1.14 1.14 1.14 1.14 EBIT 1.18 0.99 1.23 2.79 4.77 7.26 7.13 Interest paid 0.48 0.68 0.68 0.68 0.68 0.68 0.68 EBT 0.70 0.31 0.55 2.11 4.09 6.58 6.45 Less Tax 0.21 0.09 0.17 0.63 1.23 1.97 1.93 Net Profit 0.49 0.22 0.39 1.48 2.86 4.60 4.51 Net Working Capital Statement   2010 2011 2012 2013 2014 2015 2016 Working Capital 0.50 0.52 0.64 0.80 1.00 1.26 1.26 Net Change in Working Capital 0.06 0.02 0.13 0.16 0.20 0.25 0.00 Cash Flow Statement for the Project The project will incur £5million in 2011. We will use the cash flow formula to forecast the future cash flows 2011 2012 2013 2014 2015 2016 -3.66 1.40 2.46 3.80 5.49 5.65 Incremental Cash flows from the project Incremental cash flows can be obtained by deducting the cash flows obtained without undertaking the project which we calculated initially. 2011 2012 2013 2014 2015 2016 -5.07 -0.05 0.96 2.25 3.90 4.01 NPV of the Project: The marginal cost of capital will be 8.60% - .04% So we will use 8.56% as a discount rate. = -5.07 -0.05/(1+.0856)1+0.96/(1+.0856)2-2.25/(1+.0856)3-3.90/(1+.0856)4-4.01/(1+.0856)5 NPV = £2.69 Since both of the projects have a positive NPV therefore we will select both of the projects if they are not mutually exclusive. The greatest uncertainty in the project lies within the growth rate and inflation rate since a minor change in them can cause the results obtained to be invalid. If the economy flatters, than the chances that the company will grow lowers and can have profound consequences on the result of the company. 2) There could have been several other methods which we could have used to analyze the projects such as payback method, Internal Rate of return method, and Profitability index. NPV and IRR are the most common methods of DCF and they have been extensively used by corporations to evaluate their capital projects. However, these methods are time consuming and costly than the other principle techniques. In many countries such as United Kingdom, Payback method has been given top priority by the corporate managers because of its ease of use and simplicity (Sangster, 1993). NPV method is criticized because the discount rate factor is most vulnerable to affect the conclusion of the projects and it is very difficult to estimate the appropriate discount rate since future is uncertain (Longbottom, 1977). In addition to that, an implicit assumption about NPV method is that cash flows can be reinvested at the cost of capital which is not always a true assumption. Similarly, IRR is also dogged by huge problems. Many of the projects have different cash flow profiles as some projects provides high return during earlier periods while lower returns at the end of the projects. This ends up a greater IRR which exaggerates the profitability of the project. Secondly, IRR sometimes produces conflicting results with NPV method. Projects with different sizes are a common example of having different IRR’s and NPV. 3) Operating Implications of undertaking the Option 2 Option 2 has several operating implications which we are described below The company has diversified itself by moving to the retail industry. However, customers are still unaware of the retail brand which will require a huge investment in marketing and distribution infrastructure The supply chain has to be managed properly since it can increase the cost of holding the inventory and lost sales which can spoil the reputation of the company. Human capital has to be trained since the company will be interacting to customer on individual basis. Competition will be stiff and the company needs to innovate in order to cater to the needs of different segments of the market. Technology plays a vital role in automation of the process at the customer end. This can increase the cost but can have outstanding long-term outcomes. 4.1 ) If the organization has an access to unlimited funds than it will choose projects which have the highest NPV since it will add the greatest value to the shareholder’s wealth. The unlimited funds also provide the organization to take risk therefore it can expand internationally and build a plant to increase its net wealth since it has access to unlimited funds. 4.2) This question pertains to capital rationing which means that an organization has limited amount of fund and needs to maximize its return. It is evident from the case that option 2 is the feasible option since it provides almost the same level of value at a lower level of investment. We can use profitability index also to judge that the second option is better since it will have a higher profitability index. Therefore the firm will go for option 2 which has a higher ROE and profitability index. References Longbottom, D. A., 1977, Capital Appraisal and the Case for Average Rate of Return. Journal of Business Finance & Accounting, 4(4), p.419-426, Sangster, A. 1993, Capital Investment Appraisal Techniques: A Survey of Current Usage. Journal of Business Finance & Accounting, 20(3), p.307-332 Read More