Capital Budgeting: Working Computers Inc - Essay Example

Capital Budgeting: Working Computers, Inc. Capital Budgeting: Working Computers, Inc. Principles of finance are fundamental concepts within business organizations. Every organization needs to understand their performance on the basis of the identified principles of finance1. Principles of finance in most cases provide a basis or benchmark upon which organizations can judge their performance. One of the significances of principles of finance is to assist in capital budgeting decisions. Capital budgeting decisions are made on the basis of various principles of finance that include NPV, IRR, ARR, and Payback Period amongst others2. On the basis of the above principles of finance, the following is an analysis and evaluation of the financial performance of Working Computers, Inc. with a view of evaluating the capital budgeting decision. Question One: Cash Flow Tables Solution: Cost of Goods Sold (COGS) and Operating Expenses: In order to calculate the cash flows for the two scenarios, with and without the investment, it is important to establish the net profits that are targeted in every fiscal year on the basis of the forecasted sales3. The following tables show the net profit obtained from the two scenarios With Investment Year Units Sold Unit Price Total Sale COGS Operating Expenses Net Profit 2003 300,000 495 148,500,000 80,190,000 38,610,000 29,700,000 2004 150,000 495 74,250,000 40,095,000 19,305,000 14,850,000 2005 189,000 495 93,555,000 50,519,700 24,324,300 18,711,000 2006 246,000 495 121,770,000 65,755,800 31,660,200 24,354,000 2007 264,000 495 130,680,000 70,567,200 33,976,800 26,136,000 2008 264,000 495 130,680,000 70,567,200 33,976,800 26,136,000 2009 264,000 495 130,680,000 70,567,200 33,976,800 26,136,000 In the above calculations, the COGS are 54% of the Total Sale whereas the Operating Expenses is 26% of the total sale. The net profit is obtained by subtracting both the COGS and Operating Expenses from the Total Sale: COGS = 0.54*Total Sale Operating Expenses = 0.26*Total Sale Net Profit = Total sale – (COGS + Operating Expenses) Without Investment Year Units Sold Unit Price Total Sale COGS Operating Expenses Net Profit 2003 300,000 495 148,500,000 89,100,000 35,640,000 23,760,000 2004 150,000 495 74,250,000 44,550,000 17,820,000 11,880,000 2005 102,000 495 50,490,000 30,294,000 12,117,600 8,078,400 2006 57,000 495 28,215,000 16,929,000 6,771,600 4,514,400 2007 48,000 495 23,760,000 14,256,000 5,702,400 3,801,600 2008 48,000 495 23,760,000 14,256,000 5,702,400 3,801,600 2009 48,000 495 23,760,000 14,256,000 5,702,400 3,801,600 In the above calculations, the COGS are 60% of the Total Sale whereas the Operating Expenses is 24% of the total sale. The net profit is obtained by subtracting both the COGS and Operating Expenses from the Total Sale; COGS = 0.6*Total Sale Operating Expenses = 0.24*Total Sale Net Profit = Total sale – (COGS + Operating Expenses) Taxation: Given that the Marginal Tax rate = 34%, all the net profits obtained above will have to be reduced by the same amount. Tax rates are calculated on the basis of the net earnings. For instance, for 2004, Tax = 0.34*14,850,000 = 5,049,000 Therefore, the net pay = 14,850,000 – 5,049,000 = 9,801,000 The following table shows Net Cash flows without taking considerations of the Working Capital Items (Accounts Payable, Accounts Receivable, and Inventory) and the Residual Value After the depreciation: With the investment Year Cash Flow Tax Expense Net Cash Flow Yr 0 (74,000,000) 0 (74,000,000) Yr 0 29,700,000 10,098,000 19,602,000 Yr 1 14,850,000 5,049,000 9,801,000 Yr 2 18,711,000 6,361,740 12,349,260 Yr 3 24,354,000 8,280,360 16,073,640 Yr 4 26,136,000 8,886,240 17,249,760 Yr 5 26,136,000 8,886,240 17,249,760 Without the investment Year Cash Flow Tax Expense Net Cash Flow Yr 0 (56,000,000) 0 (56,000,000) Yr 0 23,760,000 8,078,400 15,681,600 Yr 1 11,880,000 4,039,200 7,840,800 Yr 2 8,078,400 2,746,656 5,331,744 Yr 3 4,514,400 1,534,896 2,979,504 Yr 4 3,801,600 1,292,544 2,509,056 Yr 5 3,801,600 1,292,544 2,509,056 Depreciation: The depreciations calculated on both case will be represented in the following tables: Depreciation for the Recovery Allowance $18m MARCS 5-yr Class Yr Value Depreciation Amount of Depreciation Ending Book Value 2004 18,000,000 0.20 3,600,000 14,400,000 2005 14,400,000 0.32 4,608,000 9,792,000 2006 9,792,000 0.19 1,860,480 7,931,520 2007 7,931,520 0.12 951,782 6,979,738 2008 6,979,738 0.11 767,771 6,211,966 2009 6,211,966 0.06 372,718 5,839,248 Total Depreciation 12,160,752 Depreciation for the Recovery Allowance $56m MARCS 10-yr class Yr Value Depreciation Amount of Depreciation Ending Book Value 1999 56,000,000 0.1 5,600,000 50,400,000 2000 50,400,000 0.18 9,072,000 41,328,000 2001 41,328,000 0.14 5,785,920 35,542,080 2002 35,542,080 0.12 4,265,050 31,277,030 2003 31,277,030 0.09 2,814,933 28,462,098 2004 28,462,098 0.07 1,992,347 26,469,751 2005 26,469,751 0.07 1,852,883 24,616,868 2006 24,616,868 0.07 1,723,181 22,893,687 2007 22,893,687 0.07 1,602,558 21,291,129 2008 21,291,129 0.06 1,277,468 20,013,662 2009 20,013,662 0.03 600,410 19,413,252 Total Depreciation 36,586,748 In the above tables, the calculations on the basis of MARCS are as follows: For Yr 1; Amount of Depreciation = MARCS Depreciation rate * the Book Value For Yr 2-10; Amount of Depreciation = MARCS Depreciation rate * (Ending Book Value of Previous Year) Ending Book Value = The Yr’s Book Value – Amount of Depreciation For example; For Yr 2, the Ending Book Value = Book Value for Yr 2 – Amount of Depreciation Ending Book Value = $50,400,000 - $9,072,000 = $41,328,000 Depreciation Calculations for Yr 3 Ending Book Value for Yr 2 * MARCS Depreciation Rate for Yr 3 Amount of Depreciation for Yr 3 will be calculated as follows: Amount of Depreciation = $41,328,000 * 0.14 = $5,785,920 NB: All the calculations are done in the attached Excel File. From the above depreciation calculations, the salvage values are 5,839,248 for the investment and 19,413,252 without the investment. These values are important in establishing the final net cash flow. Working Capital Accounts: The working capital accounts include the inventory, accounts receivable and the accounts payable. Working capital is obtained from the difference between current assets and current liabilities4. In this case, the inventory and the accounts receivables are current assets while the accounts payable is current liabilities. The following tables show the changes in working capitals on the basis of inventory, accounts receivable, and current liabilities5. The net working capital will affect the scenario where the firm opts to invest the $18 million. Changes in Working Capital Year Inventory Accounts Receivable Accounts Payable Working Capital 2003 6,000,000 3,000,000 2,000,000 7,000,000 2004 6,000,000 3,000,000 2,000,000 7,000,000 2005 6,000,000 3,000,000 2,000,000 7,000,000 2006 6,000,000 3,000,000 2,000,000 7,000,000 2007 6,000,000 3,000,000 2,000,000 7,000,000 2008 6,000,000 3,000,000 2,000,000 7,000,000 2009 6,000,000 3,000,000 2,000,000 7,000,000 On the basis of the above, the following tables show the final net cash flows for the two scenarios without taking considerations of the interest: With Investment Yr Cash flow after Tax Working Capital Net Cash Flows Yr 0 -74,000,000 0 -74,000,000 Yr 1 19,602,000 7,000,000 26,602,000 Yr 2 9,801,000 7,000,000 16,801,000 Yr 3 12,349,260 7,000,000 19,349,260 Yr 4 16,073,640 7,000,000 23,073,640 Yr 5 17,249,760 7,000,000 24,249,760 Yr 6 23,089,008 7,000,000 30,089,008 Without Investment Yr Cash flow after Tax Working Capital Net Cash Flows Yr 0 -2,318,400 0 -2,318,400 Yr 1 7,840,800 0 7,840,800 Yr 2 5,331,744 0 5,331,744 Yr 3 2,979,504 0 2,979,504 Yr 4 2,509,056 0 2,509,056 Yr 5 21,922,308 0 21,922,308 In the above calculations, the working capital is added to the cash flow after tax6 based on the assumptions discussed later on in the paper. In the second scenario where Working Computers, Inc. has no intention of investing the $18 million, there are no changes in the working capital. The increase in Accounts receivable, Inventory, and Accounts Payable contributed to a net increase in the working capital7. NB: All the above calculations are shown in the attached Excel file. a). The increase in accounts receivable, accounts payable, and inventory are supposed to be included in marking the capital budgeting decisions8. It is important to adjust for the net working capital changes that are likely to occur given a change in investment portfolio. Therefore, in considering these items, the following assumptions were made: I. The net working capital expected was to be as a result of the change of investment involving an increase of $18 million9 II. It is also assumed that the capital budgeting project in question requires additional working capital10, that is, it requires additional current assets whilst at the same time giving rise to current liabilities III. As more revenue is generated so does the amount of working capital required to increase such revenue increases11. IV. The last assumption is that at the end all the working capital will be turned into cash flows12. b). The $18million-term loan and yearly interest expenses should not be included in the cash table. This is because the cash tables are aimed at identifying whether it is viable to engage in the investment. In the event that the analysis proves that it is viable to have the investment, then the loan will be acquired in order to process the investment. The following is based on the following assumptions I. The loan and the yearly interest expenses are assumed to be financial costs13. Financial costs should not be included in the evaluation of a project II. It is assumed that these financial costs involved are already included within the cost of capital or discounting rate14, which is used in conducting the evaluation of the capital budgeting project III. It is assumed that since the financial costs are already included within the cost of capital or discounting rate, including them in the evaluating process would amount to double counting thus rendering the evaluation ineffective15. c). Recovery (i.e. depreciation) allowance for the $56 million made in early 1999 and the $18 million new investment are not included in the evaluation of the capital budgeting project. Their inclusion is based on the following assumptions: I. Over time the accrued depreciations do not form part of cash flows. In evaluating the capital budgeting project is required that cash flows should be considered16. II. It is also assumed that the depreciations are written-off over the life of an asset or investment in this case17 III. The last assumption is that whereas depreciation does not form part of cash flow, it is going to affect the actual tax expense since it defines the net profit of a project or an investment in this scenario. d). The terminal value for the division at the end of 2009 is included as a cash flow in year 5. The main assumptions that lead to the inclusion of the terminal/salvage value are: I. It is assumed that a normal project would not have a salvage value18. In this case a positive salvage value is treated as a cash flow II. The salvage value or terminal value can attract cash of the same magnitude hence included within the evaluation19 Question Two: Analysis of the Cash Flows Based on the above cash flows, various principles of finance can be used to carry out an evaluation of the capital budgeting project in question. The principles include the NPV, Payback Period, and the IRR20. These principles are effective in making decisions as to whether to go ahead with the investment or not21. The following is an evaluation of the capital budgeting project of Working Computers on the basis of Payback Period, Net Present Value, and Internal Rate of Return methods or principles. Payback Period Method Payback period method involves determination of the number of years it will take to recover the initial investments22. In this case, it is only the capital budgeting project that will be evaluated on the basis of the $18 million amount to be invested. The following is an analysis of the payback period for the investment: Initial Investment Cost of the Existing Project 56,000,000 Additional Investment 18,000,000 Total Cost of the Project 74,000,000 From the cash flows, the collected payback can be calculated as follows: Yr Net Cash Flow Cumulative Cash Flow 1 26,602,000 26,602,000 2 16,801,000 43,403,000 3 19,349,260 62,752,260 4 23,073,640 85,825,900 5 24,249,760 110,075,660 6 30,089,008 140,164,668 From the above table, the payback period is between Yr 3 and Yr 4. In order to get the exact payback period, Therefore, the payback period is 3.4638 years, which is equivalent to 3 years and 51/2 months Decision Rule: The acceptable Payback period is 3 years. Since the calculated Payback is greater than the Accepted payback23, REJECT the investment. Net Present Value Method Net Present Value refers to the present values of all the cash flows less the initial investment on a given project24. In order to calculate the present values of the future cash flows, a cost of capital or discounting rate is needed25. In this scenario the discounting rate of cost of capital is 14.5% (0.145). Net Present Value of a project is obtained from the following formula: In this scenario, the NPV will be calculated as: Therefore, from the above calculations, the NPV is obtained as The NPV can also be obtained through the Excel. The following table represents the calculations obtained from the Excel on the NPV of the project. Yr Net Cash Flow 0 74,000,000 1 26,602,000 2 16,801,000 3 19,349,260 4 23,073,640 5 24,249,760 6 30,089,008 Prevent value $88,037,426.63 NPV 14,037,427 Decision Rule: Invest on projects with Positive NPV. Since the above project has a positive NPV, then ACCEPT and INVEST. Internal Rate of Return Method Internal Rate of Return is the discounting rate at which the Net Present value of a given project under considerations equals to zero26. Internal rate of return (IRR) is the discounting rate that equates the Net Present Value to the Initial Cost of Investment in a given project under consideration27. Internal rate of return is calculated from the following formula28: Also written as In this formula, the r that equates the present values to the initial investment is the IRR. Therefore, the IRR of the project will be calculated by: From the calculations, the IRR = 21.04% The above calculations can also be performed in Excel. The Excel calculations are attached in the Excel file. Internal Rate of Return Yr Net Cash Flow 0 -74,000,000 1 26,602,000 2 16,801,000 3 19,349,260 4 23,073,640 5 24,249,760 6 30,089,008 IRR 21.04% Decision Rule: Independent projects with a greater IRR than cost of capital should be accepted29. In this case, the IRR is 21.04%, which is greater than the cost of capital, 14.5%. Therefore, ACCEPT and INVEST in the project Based on the above three evaluation, it is the payback period that rejects the investment. Notably, the payback period is however in the range of the accepted payback period. Overall, the decision rule should be to accept and invest the $18 million into the Working Computers, Inc. portfolio since it has numerous advantages as compared to the disadvantages. Question Three: Analysis and Recommendations a). Sensitivity analysis of NPVs to unit sales and cost of capital30 All the calculations to the sensitivity analysis are in the attached Excel file. From the Excel file, the sensitivity analysis results are as follows: Unit Price -20% ($396) $495 +20% (594) NPV $2,318,615 $14,037,427 $25,756,238 Impact + 83.5% Benchmark - 83.5% Sensitivity Analysis with the cost of capital also shows that when the cost of capital is increased the NPV decreases and when the cost of capital is reduced then the NPV increases as illustrated in the following table Cost of Capital -20% (11.6%) 14.5% +20% (17.4%) NPV $21,706,021 $14,037,427 $7,319,022 Impact +54.6% Benchmark -47.9% b). Impact of sales discount on NPV From the excel functions and calculations, reducing the unit price by 20% from $495 to $396 led to a reduction in NPV from $14,037,427 to $2,318,615 (Representing 83.5% decrease in the NPV). Providing a 20% discount on the unit sale will have a negative impact on NPV irrespective of the reason for the discount. Discounts may sometimes be given to appreciate the customer who buys in bulk or encourage the customer to buy in bulk31. In this scenario, the projected unit sales are maintained hence the discount will not change the volume of sales but rather appreciate the customers32. Irrespective of the purposes of the discount, if the operating expenses and the cost of goods remain unchanged, then the net profit will reduced. The reduction in the net operating profit will cause a reduction in the net cash flows33. Net present value is linked to the cash flows and the initial investment34. Since the net cash inflows are reducing courtesy of the reducing operating profits while the initial investment is remaining constant, the NPV will reduce and may eventually become negative. The more the discount given to the customers, the greater the reduction in the sales and net cash inflows experienced within the project or the investment. Therefore, reducing the unit price by 20% through offering discounts is likely to lead to a decrease in the NPV by almost the same margin. c). Minimum Level of Sales The minimum level of annual sales for the Bernoulli product before it would be eliminated should be able to cover for the initial costs of the investment. The Bernoulli product is to be eliminated by the end of 2003. The sales should be able to meet the cost of investment after the deductions of the cost of goods, operating expenses, and the depreciation expense. The following calculations provide the minimum level of sales for the product before elimination: Depreciation expense by 2003 Initial Investment $56,000,000 Ending book value by 2003 $28,462,098 Net Book value at the beginning of 2004 $27,537,902 If sales of $27,537,902 are made, then the resulting COGS and operating expenses will be given by: Cost of goods sold 0.6*$27,537,902 = $16,522,741 Operating expenses 0.26*$27,537,902 = $6,609,097 Total (COGS and Operating Expenses) = $23,131,838 Therefore, the minimum sales that Bernoulli product should achieve before being eliminated is the amount of the amount to meet the COGS, operating expenses, and depreciation expense. Considering the amount of net profit derived in 2003, which is $23,760,000, the Bernoulli product needs additional $27,537,902 - $23,131,838 = $4,406,064 Therefore, the minimum sales by 2003 should be given by: Cost of goods sold for $4,406,064 = $2,643,638 Operating profit for $4,406,064 = $1,057,455 Total = $3,701,093 The amount $3,701,093 will cover the COGS and operating expenses. Therefore, the total will be $3,701,093 + $4,406,064 = $8,107,157 This amount will cater for the depreciation expense, additional cost of goods and operating expenses resulting from additional sales. Therefore, the total minimum level of sales in 2003 for Bernoulli before elimination is given by $8,107,157 + $148,500,000 = $156,607,157 d). Terminal Value As perpetuity, the terminal value is calculated as follows35: TV = FCFn × (1+g) WACC − g Where, FCFn = the future cash flows for the last 12 months g = perpetuity growth rate (the rate that an investor expects FCF to grow) WACC = weighted-average cost of capital Assumptions in this scenario include: FCF are likely to grow on the basis of inflation WACC is regarded as the cost of capital that has been used in discounting the same cash flows Therefore, the TV in perpetuity will be equivalent to: TV = 26,639,056 × (1+0.05) 0.145− 0.05 Therefore, TV will be $294,431,704.74 Recommendations: Working Computers should contribute the requested $18 million to the Bernoulli division given the fact that it has a positive NPV and IRR that is higher than the cost of capital. Besides, the payback period is within the range of 3 years, which is the accepted payback period. Nonetheless, the following factors would affect the decision in the above recommendations: Project Risks: If the risks involved surpass the benefits the organization is likely to derive from the project then there is a slim chance of accepting the recommendations to invest36. The recommendations will be tied to the project risks. Availability of funds: Another important factor that would affect the above recommendation is the availability of funds37. If funds are easily available then the organization can invest the $18 million. However, lack of funds or higher costs of acquiring funds will reduce the chances of the management investing the $18 million into the project. Technological resources: In order to operate the new investment, the firm will be required have the necessary technological resources included human resource38. In the event that such resources are unavailable or costly to acquire then it becomes difficult for the management to take up the investment project. In selling the Bernoulli, Working Computer should ask for a price that matches the sale as well as the salvage value of the product. In this respect, since the product has the ability of contributing to further sales for several years besides having patents, the estimate for the selling price would be: Salvage value $28,462,098 Total expected sales $59,637,600 Estimated Selling Price $88,099,698 However, this estimated selling price only covers the amount of salvage value at the point of disposal and the total expected sales that the product can generate. The estimate does not cover the patents of the product. There are other considerations that might be appropriate when a firm is considering eliminating a product line or selling a division. Amongst the considerations include: The product life cycle or the division life cycle that the firm aims to eliminate or sell The costs that will be reduced when the product line is eliminated or the division is sold The costs to be incurred as a result of the elimination of the product line or selling of the division Economical issues relating to the elimination of the product line or selling of the division. For instance, the elimination or division may cause a serious economic problem. Legal issues involved such as dumping and other regulation set Theory of constraints: The available constraining factors that might prevent the successful and smooth elimination or selling. References Anderson, John E. Public finance: Principles and policy. South-Western Pub, 2011. Banks, Erik. Finance: the basics. Routledge, 2010. Benninga, Simon. "Principles of finance with excel." OUP Catalogue (2011). Besley, Scott, and Eugene F. Brigham. Principles of finance. South-Western Pub, 2011. 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