The Corporate Finance - Example

Student’s Name: Instructor’s Name: Course Code & Name: Date of Submission: Word Count 3,119 Table of Contents 1.0 INTRODUCTION 3 1.1 CASH FLOW FORECAST 5 2.0 INVESTMENT APPRAISAL 9 3.0 Critical Analysis of Appraisal Tools 12 4.0 Decision Sensitivity 13 5.0 IMPACT OF NEW INVESTMENT 15 6.0 The Impact of the Project in Financial Market 17 Reference: 19 1.0 INTRODUCTION The expansion or venture into a new business requires in-depth analysis of various aspects of the current financial availability and return from forgone consumption. The requirement for analysis is not isolated the issue to Great Eastern Toys Company. The company has been operating in Toy industry for 20years. The industry is wishing to improve its profitability and sustainability in the market. The move is aimed at minimizing the effect of increased competition and changes in consumer preferences. The company has come up with a new project to improve its financial position. The project entails coming up with premium toys. The report evaluates this project to determine its feasibility. The analysis aims at ensuring that investors get value from their funds that are a duty of the management. The report exploited various project appraisal tools such as net present value and discounted payback method. This tool plays an essential role in coming up with the conclusive decision to be adopted by the management. The project will impact the returns, share price, and dividends. Therefore, the impact is discussed in the report to give insight to the management. 1.1 CASH FLOW FORECAST The forecast of cash flow is essential in determination of the project viability. The cash flow shows the effect of the project to real cash in and cash out from the business. The statement below shows the forecasted cash flow for five years; CASH FLOW FORECAST Category/year Metrics 0(HK$'000) 1(HK$'000) 2(HK$'000) 3(HK$'000) 4(HK$'000) 5(HK$'000) 6(HK$'000) Revenue 300 10,800.00 10,800.00 10,800.00 10,800.00 10,800.00 COGS Material costs 95.0 (3,420.00) (3,420.00) (3,420.00) (3,420.00) (3,420.00) Adjustment for Direct labour costs (1,200.00) (1,200.00) (1,200.00) (1,200.00) (1,200.00) Total (4,620.00) (4,620.00) (4,620.00) (4,620.00) (4,620.00) Gross Profit 6,180.00 6,180.00 6,180.00 6,180.00 6,180.00 Production overhead opportunity costs (80.00) (80.00) (80.00) (80.00) (80.00) Tax 80.00 (913.92) (913.92) (913.92) (913.92) (913.92) Administration Overhead Adjustment for energy costs (360.00) (360.00) (360.00) (360.00) (360.00) Other overhead costs 1.00% (108.00) (108.00) (108.00) (108.00) (108.00) Operating cash flow (80.00) (468.00) (1,461.92) (1,461.92) (1,461.92) (1,381.92) (913.92) Cost of equipments (16,000.00) Disposal 800.00 Change in Net working capital (435.00) 435.00 Investment Cash flow (16,435.00) 1,235.00 Net Cash flow (16,515.00) 5,712.00 4,718.08 4,718.08 4,718.08 6,033.08 (913.92) Cum cash flow (16,515.00) (10,803.00) (6,084.92) (1,366.84) 3,351.24 9,384.32 8,470.40 Assumptions The cash flows statement preparation assumed that the debt and credit are settled within the same year it is incurred. It does not adopt the current cash collection and payment cycle. The project is estimated to have an economic life of five years after which the assets will be disposed. The company incurs the opportunity cost of HK$80,000 by investing in the project. The forecast assumes that other overhead expenses incurred represents 1% of the revenue earned in the same period it is incurred. The tax and finance cost remains the same for the five-year period. 1.2 Profit and Loss Statement Forecast The forecast of profit and loss statement is important in evaluating the project. The statement helps in determining the effect of the project on the financial performance of the company within the project economic life (Langdon, 2002). The forecasted financial performance for the company is as shown in the statement below; PROFIT AND LOSS STATEMENT Category/year Metrics 0(HK$'000) 1(HK$'000) 2(HK$'000) 3(HK$'000) 4(HK$'000) 5(HK$'000) Revenue 10,800.00 10,800.00 10,800.00 10,800.00 10,800.00 COGS Material costs (3,420.00) (3,420.00) (3,420.00) (3,420.00) (3,420.00) Adjustment for Direct labour costs (1,200.00) (1,200.00) (1,200.00) (1,200.00) (1,200.00) Total (4,620.00) (4,620.00) (4,620.00) (4,620.00) (4,620.00) Gross profit 6,180.00 6,180.00 6,180.00 6,180.00 6,180.00 Production overhead 1% (108.00) (108.00) (108.00) (108.00) (108.00) Energy cost (360.00) (360.00) (360.00) (360.00) (360.00) Market Research (500.00) EBTDA (500.00) 5,712.00 5,712.00 5,712.00 5,712.00 5,712.00 Tax 0.16 80.00 (913.92) (913.92) (913.92) (913.92) (913.92) Depreciation (1,520.00) (1,520.00) (1,520.00) (1,520.00) (1,520.00) Finance costs (1,491.50 ) (1,339.50 ) (1,187.50 ) (1,035.50 ) (883.50) Loss on disposal (7,600.00) PAT (420.00) 1,830.8 1,982.08 2,134.08 2,286.08 (5,161.92) Operating profit (500.00) 4,192.00 4,192.00 4,192.00 4,192.00 4,192.00 Assumption The assets are assumed to have an economic life of 10 years. The depreciation is distributed to the ten year period in determining yearly depreciation. The finance charge arises from the loan borrowed to fund the project by complimenting cash available in the business. The interest rate is assumed to be compounded at 10%, and it is constant for the five years. The cost of goods sold constitutes labour charges. The production overhead is estimated to be 1% of the revenue both earned and incurred in the same period. 1.3 Cash flow and profit/loss statement difference Cash flow and statement of financial performance exhibits differences. The difference arises from the items required to be included and period. The table below shows the differences between these two statements; Difference between Cash Flow and Profit/Loss Statement Item Statement recorded Comments Opportunity cost Cash flow The item is recorded in cash flow statement but not recorded in profit/loss statement. The item represents income lost by investors in foregoing, other consumption needs to invest in the project. The cost is estimated to 80,000 incurred at year zero to year 4. The recording is required by international standards on costing principal and opportunity costs notion. TAX Cash flow Profit and loss The tax rate is at 16%, the company receives tax relief in year zero for profit and loss and year one for cash flow statement. The recording of the tax obligation in the two forecast statements is different. The cash flow statement records tax in the year that it is being paid because cash flow statement records only real cash inflows and outflows. On the other hand, profit and loss statement realizes tax when it is incurred since it is associated with the income earned during that period. Change in Net working capital Cash flow The change in net working capital (HK$435,000) is recorded only in the cash flow statement at year zero. The change is arrived at adjusting creditors, debtors, and cash required during the beginning of the project i.e. capital needed to run the business before it becomes profitable. The amount is cashed in after the end of project life. In the case of the company, this will happen during the fifth year. It is not recorded in the profit and loss statement because it is considered initial investment thus does not fall within income or expense category. Cost of equipment. Cash flow The cost of equipment of HK$16 is recorded in cash flow statement but not recorded in the profit and loss because it doesn’t fall into the category of income or expense. The cost is recorded at year zero and disposal value (HK$800,000) is cashed in at the end of the project life. Depreciation Profit and loss The depreciation is not recorded in the cash flow statement because it is not incurred by the company. The depreciation acts as a provision that the company can use in replacing the asset at the end of its economic life. Cash flow statement records real cash inflows and outflows only. 2.0 INVESTMENT APPRAISAL The investment is appraised using three methods, these methods includes NPV, payback and internal rate of return. 2.1 Payback The company needs to estimate the period within which the project is going to pay back the capital invested. The payback technique adopted includes traditional and discounted payback methods. Traditional payback technique is as shown below; Year Cash flow (HK$ ‘000’) Cumulative cash flow (HK$ ‘000’) 0 -16,515.00 -16,515.00 1 5712.00 -10803.00 2 4718.08 -6084.92 3 4718.08 -1366.84 4 4718.08 3351.24 5 6033.08 9384.32 Payback period 3.29 or 3 years and 3months The evaluation of discounted payback technique is provided below; Year Cash flow (HK$ ‘000’) Cumulative cash flow (HK$ ‘000’) 0 -16,515.00 -16,515.00 1 4951.46 -11,563.54 2 3545.31 -8018.23 3 3073.26 -4944.97 4 2664.06 -2280.91 5 2953.00 672.09 Payback period 4.77 or 4 years and 9months The project is viable since the project will pay back before the end of estimated project life of 5 years. The evaluation was done using discounted payback method since it adjusts the value of cash flow due to inflation and other factors, unlike the traditional payback method. 2.2 Internal Rate of Return The IRR is essential in appraising the project to determine the value that the investors are going to gain or loss in case they decide to invest (Langdon, 2002). The IRR of the project will be compared with the market interest rate or WAAC to determine the viability of the project. According to the company project, IRR of the project is at 16.11% that is slightly higher than the cost of capital (WAAC= 15.36%) of Great Toy. The company can pursue the project since they can realize return after settling the cost of capital. The assumption is that the WAAC remains the same for the five years. 2.3 Net Present Value This tool is very essential in appraising a project. The method adjusts for the changes in the value of money since it discounts cash flows. The NPV for the project is provided below; Year 0 1 2 3 4 5 6 FCF/(HK$’000) (16,515.00) 5,712.00 4,718.08 4,718.08 4,718.08 6,033.08 (913.92) DF 0.87 0.75 0.65 0.56 0.49 0.42 PV/(HK$’000) 4,951.46 3,545.31 3,073.26 2,664.06 2,953.00 (387.77) NPV/(HK$’000) 284,319 The company should pursue the project since the net present value is positive. The company would have rejected the project if the NPV was negative. This method is mostly preferred than the other method since it considers all the transactions that affect the project from initial to the end of project life. Assumptions The estimation made on the cash flows, and the initial cost is correct. The cost of capital remains the same for the 5 years. The project is not affected by other non-monetary related factors i.e. management or legislation. 3.0 Critical Analysis of Appraisal Tools The methods of appraisal have different merits and demerits. Therefore, a combination of these methods in analyzing investment allows one to minimize this weakness. 3.1 Payback Technique The payback periods shows the period in which the investment is going to return the amount that was invested in the project. The project is viable when the payback period is lower than the target or economic life of the project. The technique can be used to select an invest project from a range of investment. The traditional payback method does not provide for the changes in value for money thus reducing it relevance in decision making. According to Lumby (1994), this weakness is overcome by discounting the cash flow (discounted payback method). The most common disadvantage to this approach is that it does not consider cash flows after the project has break-even. 3.2 Net Present Value The net present value technique is mostly recommended for use in appraising the projects. The method considers the changes in the value of money. The cash flows are discounted to adjust for inflation in the determination of present value. The investor will be required to invest in a project when the NPV is positive and reject the project if the NPV is negative (Lumby, 1994). The weakness of this method is that it does not consider other factors that affect the project directly or indirectly. This factor includes an increase in competition, legislation or management team. 3.3 Internal Rate of Return The use of the internal rate of return technique is important and helps in making decisions on investment. This method is preferred because it is easy for users of information to understand and compare various projects (Lumby, 1994). Also, the method provides for the time value of money which makes the result more relevant in an economy with fluctuating level of inflation. 4.0 Decision Sensitivity Sensitivity analysis is essential in determining the effects of particular variables on NPV of the project. The determination is used by management in stimulating these variables to achieve the set goals after implementation of the project (House, 1968). This report analyses sensitivity of five variables which includes; 4.1 Sensitivity analysis for Gross Profit Year 1 2 3 4 5 PV of Gross profit 5,357,143 4,643,848 4,025,527 3,489,534 3,024,908 Sum of PV of gross profit 20,540,960 sensitivity percentage 1.384% The table above shows that the gross profit has a sensitivity of 1.384%. The gross profit is less sensitive in the project, but the company needs to keep the gross profit in check to ensure that the project achieves maximum performance. 4.2 Sensitivity for labor cost Sale Price adjustment -20% -5% 0% 5% 20% 60% NPV Value 365,490 307,510 284,319 259,967 186,913 -7897.61 The table above shows that the decrease in labor cost by 15% (20%-5%) results to increase in NPV by 57,980 (365,490-307,510). The rise in labour cost greatly reduces the NPV of the project. Therefore, the company needs to look into best ways to reduce labour cost without affecting service delivery or overworking the employees’ workload. 4.3 Sensitivity analysis for Sales price Sale Price adjustment -5% -1% 0% 1% 5% NPV Value -1,246,126 -21,770 284,319 590,407 1,814,763 The table below is evident that the sale price is highly sensitive. The change in price by a small proportion result to the huge change in the NPV of the project. The company should consider taking in-depth analysis since proper pricing can yield company significant return. Consequently, inadequate pricing will result in bad performance. 4.4 Sensitivity analysis for COGS Year 1 2 3 4 5 PV of COGS (4,004,854) (3,471,614) (3,009,374) (2,608,681) (2,261,339) Sum of PV of COGS (15,355,864) Sensitivity percentage -1.85% The cost of goods sold is less sensitive to NPV of the project. This does not mean that management can ignore monitoring the variable. The management should keep it under control but less preferential to other variables. 4.5 Sensitivity for price of raw material per unit Raw Material adjustment -5% 0% 5% NPV Value 764,115 284,319 -219,468 The cost of raw material is highly sensitive in affecting NPV of the project. A Little increase in the cost of raw material results in a massive decrease in NPV and vice versa. The company should find a supplier with favorable price by tendering the supplies or improving suppliers’ terms. 5.0 IMPACT OF NEW INVESTMENT The investment requires to be appraised using the relevant WAAC. According to Savvides (1994), the use of proper discounting factor increases the relevance of the NPV in decision making. The previous calculation assumed that the WAAC of the company will remain the same. The low WAAC signifies little risk while high WAAC represents a high risk (Langdon, 2002). Below is illustration on calculation of the new WAAC and data analysis; Charley Hills Data Analysis Competitor Beta 1.20 Share price 5.2 Shares issued 15000000 Bond Per Value 30000000 Risk Free rate 9% Expected return 20% Annual Coupon Rate 11% Total Equity 78000000 Debt + Equity 108000000 Yield to Maturity 10% Tax 16% Maturity of Bond Year 0 1 2 3 4 5 6 7 -100 11 11 11 11 11 11 111 Present 0 1 2 3 4 5 Cash flow 103.7907 10 9.0909 8.2645 7.5131 68.9223 Total debt 31137236.03 Cost of equity 22.20 WAAC 18.46% The new project WAAC is obtained by use of competitors’ beta 1.20. This is shown in the table below; Un-gearing BG 0.899 Re-geared BG 1.40 Cost of Equity 24.42 WAAC 18.01% The table below shows the NPV for the adjusted WAAC; New NPV Year 0 1 2 3 4 5 6 FCF(HK$'000) (16,515.0) 5,712.0 4,718.1 4,718.1 4,718.1 6,033.1 (913.9) DF 0.85 0.72 0.61 0.52 0.44 0.37 PV(HK$'000) (16,515.0) 4,840.2 3,387.7 2,870.7 2,432.5 2,635.7 (338.3) NPV(HK$'000) (686.6) Charley Hills data shows that the NPV of the project reduced from HK$284320 to (HK$685680). The internal rate of return reduced to 16% while the WAAC increased to 18.01%. This is because there is increased risk in the new investment which is associated to the beta used in finding WAAC. The company can change the capital structure to reduce the cost. This can be achieved by finding the best mix of equity and debt in financing the project, for instance increasing debt. The new WAAC results to negative NPV, which means that the project is not profitable. The management should reject the project or change the capital structure. 6.0 The Impact of the Project in Financial Market The shareholders expectation in any given investment is to get value from their investment by foregoing their consumption. The major areas of analysis by an investor before making the investment are to understand the movement of the share price (capital gain) and dividends payout (Sethi, n.d.). The company can decide to pay out the high dividends prior issue of additional capital to bring signaling effect to the business performance that will play a great role by increasing demand for the company shares. This will enable the company to finance the project easily since the shares will be fully subscribed within a short period. According to Farrar (1999), the company should take into consideration existing shareholders by not issuing excess equity that will dilute the current ownership thus reducing control and dividends payout. Also, excess issue of shares can lead to expensive due to failure in achieving optimum capital structure. Though, Modigliani and Miller on irrelevance theory suggest that the cost of capital structure do not change with changes in the debt and equity mix, this theory does not hold since the market is not perfect (Miller and Modigliani, 1961). Consequently, the company might agree to adopt residual principle regarding the payment of dividends. This is achieved by not to pay out dividends to invest the profits in the new product line. This will send a negative signal to the market since investors will presume that the company is not making any profit (Fleischer, 1969). This will result to drop in the share price of the company forcing investors to sell their shares. The effect will be short-term since the investors will learn about company strategies and reasons why they didn’t pay out dividends. The prices will then rise steadily because company investment promises a greater return in future than their current consumption needs. The return will entail high capital gain because of share price appreciation and high future dividends as a result of increased profitability (Frankfurter, Wood and Wansley, 2003). In conclusion, the company should ensure that the capital structure is optimal and disseminate enough information in the capital market. This is because any change in dividend policy will impact market capitalization of the business (Chetty and Saez, 2007). Also, the business is undertaking a risky project that attracts investors who are risk takers. These types of investors have a high appetite for risky investment but with calculated move. Therefore, Great Eastern Toys needs to provide enough information to these investors to ease equity subscription and reduce the effect on market capitalization of the company. Reference: Chetty, R. and Saez, E. (2007). An agency theory of dividend taxation. Cambridge, Mass.: National Bureau of Economic Research. Farrar, S. (1999). Tax and optimal capital budgeting decisions. Aldershot: Ashgate. Fleischer, G. (1969). Capital allocation theory. New York: Appleton-Century-Crofts. Frankfurter, G., Wood, B. and Wansley, J. (2003). Dividend policy. Amsterdam: Boston. House, W. (1968). Sensitivity analysis in making capital investment decisions. [New York]: National Association of Accountants. Langdon, K. (2002). Investment appraisal. Oxford, England: Capstone Pub. Lumby, S. (1994). Investment appraisal and financial decisions. London: Chapman & Hall. Miller, M. and Modigliani, F. (1961). Dividend Policy, Growth, and the Valuation of Shares. J BUS, 34(4), p.411. Savvides, S. (1994). Risk analysis in investment appraisal. Project Appraisal, 9(1), pp.3-18. Sethi, S. (n.d.). Extension of 'Dividend Policy, Growth, and the Valuation of Shares' by Miller and Modigliani (1961) to Allow for Share Repurchases. 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