Corporation Finance: BH Tinto Investment Analysis - Assignment Example

Finance paper Part (1) Workings Given: $000. Company A Purchase cost 100,000 Installation costs 5,000 Life time 6 years Salvage value 5,000 Initial working capital 80,000 Annual cash follows 150,000 Operating expenses 102,000 Finance rate, 6yrs 10% p.a. compounded. Machine B. Purchase cost 150,000 Installation costs 4,000 Life time 10 years Salvage value 2,000 Initial working capital 70,000 Annual cash follows 155,000 Operating expenses 95,000 Tax rate 30% Depreciation policy, straight line method up to zero value. ASX200, Australian market values, is 09% Standard deviation of ASX200 25% Standard deviation of BH Tinto 35% Expected return on ASX200 is 12% Risk free rate is 7% The firm is 100% equity financed Project evaluation analysis Computation of initial capital outlay. Project A. $000 Calculating initial capital outlay 100,000 Installation cost 5,000 Project cost 105,000 Working capital released 80,000 Total capital 185,000 Computation of annual cash flows. Annual cash flows 150,000 Operating expenses -102,000 Annual net cash flows 48,000 Project evaluation, NPV analysis. (A) Year cash flows factor (10%) discounted cash flows 0 185,000 1.0 (185,000) 1 48,000 0.909 43,632 2 48,000 0.826 39,648 3 48,000 0.751 36,048 4 48,000 0.683 32,784 5 48,000 0.620 29,760 6 48,000 0.564 27,072 6 5,000 0.564 2,820 Net present values 26,764 NPV=Total discounted cash flows less initial outlay: =211,764 -185,000=26,764 Therefore machine A has a positive NPV. Project B. Calculating initial capital outlay 150,000 Installation cost 4,000 Project cost 154,000 Working capital released 70,000 Total capital 224,000 Project evaluation, NPV analysis. (A) Year cash flows factor (10%) discounted cash flows 0 224,000 1.0 (224,000) 1 60,000 0.909 44,232 2 60,000 0.826 40,193 3 60,000 0.751 36,544 4 60,000 0.683 33,235 5 60,000 0.620 30,169 6 60,000 0.564 27,444 7 60,000 0.513 24,963 8 60,000 0.467 22,724 9 60,000 0.424 20,632 10 60,000 0.386 18,783 10 2,000 0.386 772 145,352 Net present values NPV=Total discounted cash flows less initial outlay: =369352 - 224,000=145,352 Therefore machine A has a positive NPV. Through the Net Present Value approach machine B is better is better than machine A. it is advisable to go for machine B. It has a higher return than machine A. however; both machines have a positive NPV. If the management would wish to in invest in a short period, still machine A would be better. This is due to the risks involved in project in investment. The shorter the period the better for the project to avoid many risks involved. Also the costs involved should be considered especially if the management not interested in taking up a project with a lot of cash outlay still machine A is preferable. Theoretically, when projects are evaluated, the NPV method of approach considers projects with positive NPV. Other small comparison factors the management ideally are the final decision makers as long as the both projects have positive value. Report to the Board. Summary This report discuses two mutually exclusive project, machine A and B and is to trying to evaluate the most viable machine which should be considered for project investment. They are alternative options which serve same purpose and compete with each other for selection. The report has considered the net present value as one of the appropriate method of evaluation. The initial cost of both machine have been calculated. The annual cash flows for both machines have also been calculated with discounted figures. The report concludes by advising the board to take machine B since it has the highest net present values in consideration. Viability of the investment. The viability of the projects depends on the investor’s choice between the available alternatives. The firm’s decision to invest in its current funds most efficiently in long term asset or project investment in anticipation of an expected flow of benefits over several years in the future. Normally these long term project involves substantial huge outlay of funds which must be planned for and have relatively high degree of risks that is the actual outcomes may deviate widely from the expected. By using the capital budgeting techniques the firm can easily determine the viability of the projects which is proposed. There are various approaches used to determine the viability of the project, the non discounted method like the pay back period and Accounting rate of return. The discounted methods include the net present values, the internal rate of return and profitability index. (Horne. J.C.V & Wachowicz Jr. M. J, 2001).the report choose on the net present value approach since it considers all cash flows associated with the project and recognizes time value of money and also takes into account the risk and uncertainty inherent in a project (Brealey A. R. & S. Myers, 2002). The viability is guided by evaluating individual proposals to see whether such projects are meeting the firm’s requirement. The shareholders wealth maximization is the basic goal that is; no other corporate goal influences the investment evaluation selection process (Brealey A R & S. Myers, 2002).the net present value method of approach is the present value of the project proposed net cash flows minus the initial capital injected to the proposed project. (Horne J.C.V & Wachowicz Jr. M. J, 2001). According to the machines, the viable one is machine B. machine B has a higher returns compared with machine A. however, machine A has a less capital outlay compare with B and also shorter period than machine B. The management can decide to choose any of the two machines since both have a positive net present values. This is an indication that any of them is viable for investment. Other comparisons. Return on equity =risk free rate + Bj (mkt –RF) Costs of capital Re=RF+Bj (Rm- Rf) ASX200=0.07+0.09(0.25-.07) =0.07+0.0162 =0.0862*100% =8.62% BH Tinto Re = RF + Bj (Rm - Rf) =0.07 + 0.09(0.35 – 0.07) =0.07 + 0.0252 =0.0952 * 100% =9.52 % Conclusion. Using the return on cost of capital, still machine B is better than machine A as is indicated above calculations. The board should take machine B but without considering the huge capital outlay and the economic life of ten years since has higher return than machine A. Part (2) Corporate tax is a retirement all limited liability companies must submit. It is one of the operating expenses incurred by the firm. Much as corporation tax reduces the revenues for the entity, the business which invests in machinery and equipment stands to gain. This is because capital expenditure has a partial tax allowance on equipment and machinery. When the tax rate increases, the tax expenses also increases, which reduces the cash flow generated. However when analyzing the capital allowances, the tax shield which is deducted will have a positive effect since will reduce expenditure hence increases the disposable cash flow generated. Tax shield is part of cash inflow. BH Tinto is bound to benefit from the high tax shield if the government programs take effect. Part (3) According to Proxy Company where the initial outlay was 2000 with a beta coefficient of 1.5 and expected return of 2385, all figures in a thousand dollars had a capital asset price of 18.5%. This company was efficient given that, risk free was 8 % against the Rm of 15%. Given such analysis BH Tinto, machine B is still efficient. Cost of capital is the standards measure on which project is the above evaluated as above. In a portifolio theory risk is measured using the standard deviation, which is a total risk whereas in CAPM risk is measured using the Beta ,the non –diversifiable risk thus CAPM assumes risk is completely eliminated (Horne. J .C.V & Wachowicz Jr. M. J, 2001). Report to the Board. Summary The report discuses data analysis from a listed company so as to compare how BH Tinto will reflect when listed in the stock exchange and whether it will be a viable project. There are two comparative figures taken from the proxy company and the analysis showed that the company can invest in machine B. It is better than the listed company. Main points The analysis has considered beta and the market rate risk analysis to check on the variations in the return of securities using such factors in a given market. This helps the company to estimate its entry point in the market and also the market competition in a given period. There are many risks which affects the performance of securities in a given market. It is worthy while to note that there are risks which can be diversified and others non diversifiable risks. (Brealey A R & S. Myers, 2002)Some risk includes the political uncertainties off a country. A country where political instability persists for long discourages investors. They are not willing to risk their money since anything can happen and investors lose their money. When risk and risk free asset are mixed, the investor minimizes the level and the degree of risks involved in a security. Risk free assets are represented by government securities like treasury bills and treasury bonds (Brealey A. R. & S. Myers, 2002). The returns on investment are known with certainty and do not depend on the state of nature that may occur. A risk less or risk free assets has a zero variance, zero standard deviation and a zero correlation with any other assets. Other risk factor includes recession period like the economic changes of the country. High interest rates also affect the performance of the business. The interest changed on loan may affect the performance of the market as since high charges discourages the investor. These are unavoidable as long as the firm would want to enter into the market. They adversely affect all the firms, new and old in that given market. To minimize such risks it is advisable when BH to diversify its portfolio which provides a market based risk return trade off and also it introduces the concept of risk reduction through its formation. Conclusion It is recommended the board of BH Tinto should try to diversify their projects in order to minimize the risks involved in the market. At the same time combining risky and risk free investment is also good since the risky investment might fall but the risk free investment may save the situation in a way. When investment formed through a portfolio most of the risks are diversified since much of stand alone risk will be eliminated or diversified when the project is included into a portfolio (Horne J.C. V & Wachowicz Jr., 2001). The board of BH Tinto is advised to form a good portfolio and mix the investment. Part (4) Sensitivity analysis Summary. The report analysis sensitivity analysis which uses a number of possible variables to asses the risk inherent in an investment .The helps the investor to evaluate the risks involved a particular investment analysis is. It’s ideal to compare various methods in order to asses which one can offer a better estimate to evaluate the risks. Main points Sensitivity analysis can be used to asses the inherent risks in an investment decision. An inherent risk is a risk which might occur and is never expected (Brealey A. R. & S. Myers, 2002).there are various approaches investor can asses or evaluate risk by use of decision theory models, simulation analysis, scenario analysis and sensitivity analysis (Brealey A. R. & S. Myers, 2002). In an investment where two projects are being compared, it is likely a firm to face inherent risk as most of the assessment is made without considering other factors generally affecting the market. However consideration was made to use sensitivity analysis since it can be used to assess the risk inherent in an instant decision and also can be used to determine the critical variables which can easily affect the decision proposal (Horne J.C. V & Wachowicz Jr., 2001). Conclusion Sensitivity can give a more reliable report since it compares the inherent risk .however it also good to use various method to test on the risk of a project since it involves huge amount of money and it is advisable to be through on all areas which can bring negative impact on the future of the firm. Reference: Horne J. M. V. & Wachowicz Jr.J. M, (2001), Fundamentals of Financial Management, 11th edition. Brealey A. R. & Myers S. C. (2002), Principles of Corporate Finance, 6th edition Read More