Corporate Finance - Roger Davis - Case Study Example

1. Executive Summary Roger Davis is a financial analyst for a division in a company. He is having a tough time convincing the management for a project proposal. The analysis by his accountant and the additional information obtained from other sources has added to his woes. The analysis done by the accountant has been revisited in this report taking into account all additional information available and using discounted cash flow technique. However, the Net Present Value of the project was still found to be unfavourable. Thereafter, all the information was deeply investigated and certain pieces of information were found to be irrelevant or unfair for taking the investment decision. After eliminating those pieces, it was found that the NPV was favourable. Moreover, other analysis methods also proved the project to be profitable. After financial analysis, impact on other project has been assessed. The report is limited to only the parameters needed for the same. Any comments can’t be made on the same with given information. Lastly strategic factors have been assessed and recommendations have been provided to Roger. 2. Situation Roger Davis, the financial analyst for Steel Tube division of Engineering Products Plc, needs to convince his managing director about the viability of a new proposal for computer numerically controlled (CNC) milling machine. The MD is not ready to spend money on the project unless it can start yielding profits within 3 years. However, the accountant’s analysis shows an overall loss for the project over the next 4 years. It won’t be prudent to expect much from the project after this period. Roger has collected a lot of additional information as well. But he has not been able to justify the viability of the project with given information. 3. Irrelevant information, Most of the information available to Roger seems relevant at first sight. However, the consultant charges of £18,000 have already been paid by the company. Hence, they would not make much difference to the investment decision. Also acquiring opening stock at the beginning of the year rather than considering the same at year end would have minimal impact on the decision (the impact due to time value of money would be very small as compared to other numbers) and hence should be neglected for analysis. In addition there are pieces of information which don not directly reflect the performance of the project and must be excluded for a fair evaluation. They would be discussed in greater detail in section 5. 4. Cash flow Analysis using all additional information The accountant’s analysis was quite limited. Therefore, additional information collected by Roger needs to be incorporated in the financial analysis (Johnson, Derek). The same has been done in Table 4.1. The methodology for the same is discussed here. Table 4.1: Cash Flow Analysis using Accountant’s Analysis and Additional Information   Year     0 1 2 3 4 Total Sales   400.00 600.00 800.00 600.00   Cost of Sales   180.00 300.00 380.00 300.00   Labour Cost   80.00 120.00 120.00 80.00   Revised Other production expenses   64.00 66.00 68.00 84.00   Depreciation   40.00 40.00 40.00 40.00   Administrative Overhead   54.00 76.00 74.00 74.00   Interest on loans   22.00 22.00 22.00 22.00   Total Cost   440.00 624.00 704.00 600.00   PBT   -40.00 -24.00 96.00 0.00   PBDT   0.00 16.00 136.00 40.00   Depreciation for Tax purpose   60.00 45.00 33.75 25.31   Cumulative Depreciation for Tax purpose   60.00 105.00 138.75 164.06   PBT (for Tax purpose)   -60.00 -29.00 102.25 14.69   PAT (for Tax purpose)   -42.00 -20.30 71.58 10.28   Net profit (for company)   -62.00 -25.30 77.83 24.97   Scrap sales 20.00 0.00 0.00 0.00 20.00   Cash benefits due to sell-off of existing machine 0.00 18.00 18.00 18.00 18.00   Additional advertising expenses -40.00 -8.00 -8.00 -8.00 -8.00   Consultant expenses -18.00 0.00 0.00 0.00 0.00   Reduction in sales of competing products   -60.00 -60.00 -60.00 -60.00   Net cash flow -38.00 -112.00 -75.30 27.83 -5.03   Discount Factor at 10% rate of return 1.00 0.91 0.83 0.75 0.68   Present value of cash flow -38.00 -101.82 -62.23 20.91 -3.44 -184.58 In the above table, all additional information has been included (including consultant fees) to calculate the net cash flows except the opening stock details (as mentioned before). The sales, cost of sales and labour cost have been directly taken from accountant’s analysis. Other production expenses have been revised by deducting 20% of the labour costs since there was a very low probability of the incurrence of these costs. The remaining cost calculations remained unchanged. After this the revised Profit before Tax (PBT) was calculated and depreciation was added to it to calculate PBDT (Profit before Depreciation & Tax). This was done to include depreciation of 25% on declining balances basis for tax purposes. These adjustments were made to calculate PBT and PAT for tax purposes. After this, the difference between actual depreciation and depreciation for tax was added back to PAT to calculate revised Net profit (Loss) for the company. The profit calculations are complete till this point. After this, other additional information was included. Scrap sales for old machine at the start of the first year and for the new machine at end of fourth year were included. Similarly cash benefits due to sale of existing machine were also included. Also, the costs on marketing, consultants and impact on competing products were deducted. All the cash flows were added to come up with net cash flow for each year. These cash flows were multiplied by discount factors at 10% rate of return. This led to the present values of the cash flows for each year. Summing the present values gave the Net Present Value. It is observed that NPV is obtained as -£184,580 which calls for a rejection of the proposal. 5. Cash Flow Analysis using relevant information It can be observed that all the information available doesn’t allow to fairly evaluate the performance of the project. Firstly, the impact on the performance of other competing products has to be excluded since it will be valid for evaluation of the company and not of the CNC project. Secondly, the consultant expenses have already been paid by the company. Hence, the cost has already been incurred and has no impact on the project performance. This cost should be included in company overheads or other expenses. The revised calculations of NPV and cash flows (Tajirian, Alex) with these changes are shown in Table 5.1. Table 5.1: Cash Flow Analysis considering only Relevant Information   Year     0 1 2 3 4 Total Sales   400.00 600.00 800.00 600.00   Cost of Sales   180.00 300.00 380.00 300.00   Labour Cost   80.00 120.00 120.00 80.00   Revised Other production expenses   64.00 66.00 68.00 84.00   Depreciation   40.00 40.00 40.00 40.00   Administrative Overhead   54.00 76.00 74.00 74.00   Interest on loans   22.00 22.00 22.00 22.00   Total Cost   440.00 624.00 704.00 600.00   PBT   -40.00 -24.00 96.00 0.00   PBDT   0.00 16.00 136.00 40.00   Depreciation for Tax purpose   60.00 45.00 33.75 25.31   Cumulative Depreciation for Tax purpose   60.00 105.00 138.75 164.06   PBT (for Tax purpose)   -60.00 -29.00 102.25 14.69   PAT (for Tax purpose)   -42.00 -20.30 71.58 10.28   Net profit (for company)   -62.00 -25.30 77.83 24.97   Scrap sales 20.00 0.00 0.00 0.00 20.00   Cash benefits due to sell-off of existing machine 0.00 18.00 18.00 18.00 18.00   Additional advertising expenses -40.00 -8.00 -8.00 -8.00 -8.00   Net cash flow -20.00 -52.00 -15.30 87.83 54.97   Discount Factor at 10% rate of return 1.00 0.91 0.83 0.75 0.68   Present value of cash flow -20.00 -47.27 -12.64 65.98 37.54 23.61 In this case, the NPV is obtained as £23,610 which is positive and hence the proposal must be accepted (McClure, Ben). Further adding on the above analysis, the administrative overheads are allocated as an apportionment of the central fixed overheads. These expenses would have incurred with or without the project. Hence while assessing the benefits of the new proposal over the old machine, these expenses can also be potentially excluded which increases the NPV further up to £176,240 as shown in Table 5.2 Table 5.2: Cash Flow Analysis after deducting Administrative Overheads   Year     0 1 2 3 4 Total Sales   400.00 600.00 800.00 600.00   Cost of Sales   180.00 300.00 380.00 300.00   Labour Cost   80.00 120.00 120.00 80.00   Revised Other production expenses   64.00 66.00 68.00 84.00   Depreciation   40.00 40.00 40.00 40.00   Interest on loans   22.00 22.00 22.00 22.00   Total Cost   386.00 548.00 630.00 526.00   PBT   14.00 52.00 170.00 74.00   PBDT   54.00 92.00 210.00 114.00   Depreciation for Tax purpose   60.00 45.00 33.75 25.31   Cumulative Depreciation for Tax purpose   60.00 105.00 138.75 164.06   PBT (for Tax purpose)   -6.00 47.00 176.25 88.69   PAT (for Tax purpose)   -4.20 32.90 123.38 62.08   Net profit (for company)   -24.20 27.90 129.63 76.77   Scrap sales 20.00 0.00 0.00 0.00 20.00   Cash benefits due to sell-off of existing machine 0.00 18.00 18.00 18.00 18.00   Additional advertising expenses -40.00 -8.00 -8.00 -8.00 -8.00   Net cash flow -20.00 -14.20 37.90 139.63 106.77   Discount Factor at 10% rate of return 1.00 0.91 0.83 0.75 0.68   Present value of cash flow -20.00 -12.91 31.32 104.90 72.92 176.24 6. Best method of Analysis While it is a fact that, the discounted cash flow or NPV method is the best method for analysis since it takes into account the time value of money. Using this method in sections 4 and 5, it has been found that the proposal is profitable. It is interesting to find that even if the company uses Payback period method (Madhumati,R) on the data presented in tables 5.1 and 5.2, the payback period is less than 3 years for the former and less than 2 years for the later. This implies that the project is profitable. The flaw was in the type of information used for analysis. Similarly, if the company decides to use a Return on Investment Approach for revised data, it would come out as strongly positive. With this discussion, it can be said that NPV or discounted cash flow is the best method to take this capital budgeting decision since it takes into account time as well as the rate of return. 7. Impact on other projects There are several parameters to judge the projects vis-à-vis other projects in case of this cash crunch. Firstly, it must be seen whether the other projects are within Steel tube division or within other divisions. If the projects lie within steel tube division, they can be compared using NPV analysis. If the projects lie outside the division, strategic impact of those projects on the company must be taken into account. Secondly, CNC project is a proposal to replace an already existing machine. Hence, not going for the project may reduce some benefits but won’t halt operations. However, there may be certain projects in the pipeline which could have an impact on the operations of the company. Such projects need to be prioritized. 8. Assessment of Strategic Factors Strategic factors need to be addressed carefully. The management must be apprised of the benefits of the new machine other than financial benefits. Since the steel tube business was quite profitable, it would have long-term impact on the business. The company had already built expertise on CNC and hence no costs would be incurred on the same. Improved product quality and greater flexibility would enrich customer experience. This would enhance the reputation and brand image of the organization. This may have a trickle down impact on other competing and non-competing products of the company as well. As far as the adverse impact on competing products is concerned, it would be non-prudent to use it as an excuse for not going with the project. There are many organizations which manufacture competing products and manage them successfully. Marketing department can play a huge role in it by creating individual brand identity for both the products. 9. Recommendations With the above analysis, Roger has a strong case to present before the managing director. Even if the managing director disagrees on removing administrative overheads, the analysis in table 5.1 should make sense to him. It is recommended that Roger pitches for the analysis in table 5.2 and settles for the analysis in table 5.1 in case negotiations are required. After getting done with the financial analysis, Roger must stress upon the strategic factors discussed above, most of which are in his favour. A combination of these steps must present a strong case for the proposal to be accepted. 10. List of References Madhumati,R.Management Science – II.Capital Budgeting,Module 2 Johnson,Derek. NPV Analysis and Applications for Competitive Intelligence.Aurura WDC. Competitive Intelligence Magazine Tajirian,Alex. Capital Budgeting Process,Chapter 9. Available from [27 August, 2011] McClure, Ben. Discounted Cash Flow Analysis.Investopedia. Available from [27 August, 2011] Read More