Lifestyle Furniture - Investment Evaluation - Statistics Project Example

Lifestyle Furniture Investment Recommendation Report Name Institution Table of Contents Lifestyle Furniture 1 Investment Recommendation Report 1 Executive Summary 2 1.1Introduction 3 2.0 Investment Evaluation 3 2.1 Incremental net cash flow 3 2.2 NPV, IRR, and PIs 6 2.3 NPV profile and explanations 7 2.4 Effects of inflation rates on projects 7 2.5 Risk analysis for alternative 1 and 2 8 2.6 Lease options and discussion 8 2.7 WACC calculations and explanations 9 3.0 Recommendations 10 4.0 Appendix 10 Executive Summary This paper uses various business analysis techniques or tools to make decisions on different investment alternative. The decision on whether to renew the existing machinery or replace it altogether with a new machinery is based on analytical calculations. The workings and calculations are found in the Appendix part of this paper. From the calculations, the firm should adopt Alternative 2, which involves replacing the existing machinery with entirely new one. This decision is arrived at after calculating the NPV for both alternatives as well as the Investment Rate of Return (IRR) and the Profitability Index (PI). The NPV of alternative 2 is higher than that of alternative 1 which is a positive indication of a better outcome. Using IRR, alternative 2 has a higher rate compared to alternative 1. This indicates that alternative 2 will yield better returns than alternative 1. Using PI, alternative 2 has a higher profitability Index as compared to alternative 1 suggesting that alternative 2 is more profitable to undertake than alternative 1. Using other considerations, we recommend that the option of leasing a new machinery be rejected. We fail to adopt the option of leasing because it will change the current capital structure making the lease an expensive affair. 1.1 Introduction Capital structure is an important aspect of any firm with future goals. It is the backbone of every firm’s financial position. A similar aspect of the capital structure is the weighted average cost of capital. These help in making the right decisions about investments. This paper will evaluate these aspects among other decision-making techniques like NPV, IRR, and PI. 2.0 Investment Evaluation 2.1 Incremental net cash flow Incremental net cash flow is the extra operating or working cash flow which a firm gets up on engaging in the acquisition of a new project or modification of an existing project. A project will be accepted if the firm’s net cash flows are positive. From the calculations, the net incremental cash flows from both alternatives are positive. They increase every year which sends a good message to analysts although not necessary for final decision making. See Appendix 1 or the table below. Incremental operating net cash flow Alternative 1 Year 0 1 2 3 4 5   -135000           Sales Revenue   800,000.00 908,000.00 1,030,580.00 1,169,708.30 1,327,618.92 Advertising and Marketing   30,000.00 30,000.00 30,000.00 30,000.00 30,000.00 Maintenance   42,200.00 42,200.00 42,200.00 42,200.00 42,200.00 Raw materials   256,000.00 290,560.00 329,785.60 374,306.66 424,838.05 Operating Costs   75,000.00 75,000.00 75,000.00 75,000.00 75,000.00 Other expenses   352,000.00 352,000.00 352,000.00 352,000.00 352,000.00     755,200.00 789,760.00 828,985.60 873,506.66 924,038.05 Add Salvage value   0.00 0.00 0.00 0.00 8,000.00 net revenue   44,800.00 118,240.00 201,594.40 296,201.64 411,580.87 Tax   13,440.00 35,472.00 60,478.32 88,860.49 123,474.26 net inflows before depreciation   31,360.00 82,768.00 141,116.08 207,341.15 288,106.61 Depreciation   25,400.00 25,400.00 25,400.00 25,400.00 25,400.00 Add back Depreciation tax shield   7,620.00 7,620.00 7,620.00 7,620.00 7,620.00 Net Cash inflows   38,980.00 90,388.00 148,736.08 214,961.15 295,726.61 Add Salvage value   0.00 0.00 0.00 0.00 8,000.00 Operating Net Cash inflows   $38,980 $90,388 $148,736 $214,961 $303,727 Cost of capital 0.17           NPV Factor   (1+0.17)^1 (1+0.17)^2 (1+0.17)^3 (1+0.17)^4 (1+0.17)^5 I.e   1.17 0.0289 0.004913 0.00083521 0.000141986 PV -135000 $45,606.60 $2,612.21 $730.74 $179.54 $43.12 Total PV/NPV $49,172 ($85,828)         Incremental operating net cash flow 49,171.00 Table 1: Incremental net operating cash flows for alternative 1 Incremental operating net cash flow Alternative 2 Year 0 1 2 3 4 5   -245000           Sales Revenue   1,000,000.00 1,135,000.00 1,288,225.00 1,462,135.38 1,659,523.65 Advertising   30,000.00 30,000.00 30,000.00 30,000.00 30,000.00 Maintenance   38,750.00 38,750.00 38,750.00 38,750.00 38,750.00 Raw materials   320,000.00 363,200.00 412,232.00 467,883.32 531,047.57 Operating Costs   58,500.00 58,500.00 58,500.00 58,500.00 58,500.00 Other expenses   345,000.00 345,000.00 345,000.00 345,000.00 345,000.00     792,250.00 835,450.00 884,482.00 940,133.32 1,003,297.57 sale of asset at 0 dep value   0.00 0.00 0.00 0.00 25,000.00 net revenue   207,750.00 299,550.00 403,743.00 522,002.06 681,226.08 Tax   62,325.00 89,865.00 121,122.90 156,600.62 204,367.82 net inflows before depreciation   145,425.00 209,685.00 282,620.10 365,401.44 476,858.26 Depreciation   44,000.00 44,000.00 44,000.00 44,000.00 44,000.00 Add back Depreciation tax shield   13,200.00 13,200.00 13,200.00 13,200.00 13,200.00 Net Cash inflows   158,625.00 222,885.00 295,820.10 378,601.44 490,058.26 Add Salvage value   0.00 0.00 0.00 0.00 25,000.00 Operating Net Cash inflows -245000 $158,625 $222,885 $295,820 $378,601 $515,058 Cost of capital   0.17         NPV Factor   (1+0.17)^1 (1+0.17)^2 (1+0.17)^3 (1+0.17)^4 (1+0.17)^5 I.e   1.17 0.0289 0.004913 0.00083521 0.000141986 PV -245000 $185,591.25 $6,441.38 $1,453.36 $316.21 $73.13 Total PV -245000 $193,875         NPV ($51,125) Incremental operating net cash flow $193,873 Table 2: Incremental net operating cash flows for alternative 1 2.2 NPV, IRR, and PIs The Net Present Value of any project is used in the determination whether to consider accepting the project and executing it or rejecting the project. It gives the probable paybacks of an investment or a certain project which are above the costs incurred in executing or implementing the project. Any project that results in a positive NPV indicates a profitable venture. For the Alternative 1 and 2, All the NPVs are negative. This shows that the projects are not profitable. Alternative 1 gives an NPV of US -$85,829 while alternative 2 gives an NPV of US -$51,127. This shows that both investments will lead to non-profitable results although alternative 2 gives a better outcome. On this regard, alternative 2 is better than alternative 1. Decision: accept alternative 2, reject alternative 1. IRR is another metric tool used in determining the level of profitability of a particular investment or project. Mathematically, it is the cost of capital of a certain project that can result in zero NPV. The IRR of Alternative 1 is 68% while that of alternative 2 is 87%. Alternative 2 results in higher profits compared to alternative 1.According to IRR, alternative 2 should be preferred to alternative 1. PI stands for Profitability Index. It shows the relationship between the revenues of a particular project and the associated or related costs. A higher profitability index indicates that the given project is more desired over the one with lower PI. Alternative 1 has a PI of 1.3 while the PI for alternative 2 is 1.7. The PI for alternative 2 is higher than that of alternative 1 suggesting that alternative 2 is likely to yield higher profits than alternative 1. All these parameters point to the same direction. They present alternative 2 as being better than alternative 1. This therefore gives the final decision on the projects that alternative 2 will be chosen over alternative 1 due to the expected results. 2.3 NPV profile and explanations The NPV profile indicates the relationship between the various cost of capital and NPVs of the selected projects. The graph shows the IRR, which is the point at which NPV equals to zero. On the graph, the NPV, and the discount rate represents an inverse relationship. (See Appendix 3). The graph also indicates the rate at which the NPV of both projects is equal. This point is called the crossover point or simply the crossover rate. It is the point of intersection between the two graphs as shown in Appendix 3. For the projects 1 and 2, the crossover rate is at 116%. This can also be determined by doing the IRR of the cash flow change between the projects as shown in Appendix 4. 2.4 Effects of inflation rates on projects Inflation affects future cash flows as well the expected sales and expenses. As shown in Appendix 5 and Appendix 6, there is a significant increase in sales as well the operating expenses leading to a substantial change in the net cash flows of the projects. According to the calculations, the eventual impact of Inflation causes a 2% decline in the sales volumes with an increase in costs by 3.8% on alternative 2. The implication of inflation on alternative 1 has a decrease in both sales and operating expenses by 5.9% and 7.9% respectively. This implies that alternative 2 is the best when inflation is taken into consideration. 2.5 Risk analysis for alternative 1 and 2 Both alternatives are subject to some level of risk. From the analysis above, alternative 2 poses a lesser risk than alternative 1 especially based on the NPV and the IRR. The two alternatives have a negative NPV although alternative 1 has positive operating cash flows. Therefore, alternative 2 can be taken as less risky as compared to alternative 1. 2.6 Lease options and discussion Leasing has its advantages and disadvantages. Advantages The essential aspect of leasing has a steady cash outflow. Leasing reduces the burden of having to pay a significant amount of money in lump sum. There is a ‘relief’ time given to the investor to look for money without a lot of pressure. This kind of arrangement encourages the purchase of high-quality assets. This is because the lessor remains the sole owner of the asset while the lessee only pays installments regarding rental expense. The lessor has to ensure the asset is high quality since he/she owns it until the final instalment is paid upon which the lessee reserves the right to purchase the asset or terminate the lease contract. Leasing results in significant taxation benefits. This is because the interest paid is treated as a business expense and hence tax deductible. This is a major reason why most firms would opt for leasing instead of buying an asset in cash. The lease debt is normally treated as an off-balance sheet item even though the interest paid is included in the P&L as a business expense. This is an advantage to the firm. Disadvantages Lease payment reduces the expected income substantially. The lease does not add value at the end of the agreement as the contract gives the lessor the right to possess the asset after the agreement. This leaves the company worse off as the company experiences a reduction in its returns. A lease in most times is termed as long term debt. This hinders the company from securing loan facilities to finance short-term projects. The process of entering into a lease agreement is quite complicated and time-consuming as well as thorough evaluation of the asset to be leased. There is a lot of documentation involved including several trips to a lawyer for witnessing. The maintenance costs, as well as the operational costs of the leased asset, remain with the lessee. These costs are a burden to the firm. 2.7 WACC calculations and explanations The weighted average cost of capital calculated using book values and market values is 6.94% and 9.84% respectively. The WACC based on market value is higher than the one based on market value. The WACC calculated using the book values may give the wrong implication of the company and hence make wrong decisions. The market value based computations of WACC are the best for decision making as they give the correct position of the firm in the market. They also aid in estimating whether a certain project is viable or not. The WACC computed on market values also gives the managers the information on whether to accept a certain project or to reject it. The values can be explained by the current cost of capital for the company. The cost of capital for the company if 17% while the market WACC is 9.84% implying that the project is likely going to yield 7.16% of every cent invested. 3.0 Recommendations From the analysis, the company should stick to the current plan of operation. The reason behind this judgment is that the two alternatives result in negative NPV. However, if the company has to carry out any expansion based on the two alternatives, then alternative 2 is better because it has a better NPV than alternative 1. Secondly, alternative 2 has a larger Profitability Index than alternative 1. This used as a basis for decision-making, then alternative 2 is better. For two alternatives, the incremental operating cash inflows show a positive figure with alternative 2 having a higher value than alternative 1. This implies that alternative one can be rejected on this regard and alternative 2 selected for implementation. 4.0 Appendix Appendix 1 Incremental operating net cash flow Alternative 1 Year 0 1 2 3 4 5   -135000           Sales Revenue   800,000.00 908,000.00 1,030,580.00 1,169,708.30 1,327,618.92 Advertising and Marketing   30,000.00 30,000.00 30,000.00 30,000.00 30,000.00 Maintenance   42,200.00 42,200.00 42,200.00 42,200.00 42,200.00 Raw materials   256,000.00 290,560.00 329,785.60 374,306.66 424,838.05 Operating Costs   75,000.00 75,000.00 75,000.00 75,000.00 75,000.00 Other expenses   352,000.00 352,000.00 352,000.00 352,000.00 352,000.00     755,200.00 789,760.00 828,985.60 873,506.66 924,038.05 Add Salvage value   0.00 0.00 0.00 0.00 8,000.00 net revenue   44,800.00 118,240.00 201,594.40 296,201.64 411,580.87 Tax   13,440.00 35,472.00 60,478.32 88,860.49 123,474.26 net inflows before depreciation   31,360.00 82,768.00 141,116.08 207,341.15 288,106.61 Depreciation   25,400.00 25,400.00 25,400.00 25,400.00 25,400.00 Add back Depreciation tax shield   7,620.00 7,620.00 7,620.00 7,620.00 7,620.00 Net Cash inflows   38,980.00 90,388.00 148,736.08 214,961.15 295,726.61 Add Salvage value   0.00 0.00 0.00 0.00 8,000.00 Operating Net Cash inflows   $38,980 $90,388 $148,736 $214,961 $303,727 Cost of capital 0.17           NPV Factor   (1+0.17)^1 (1+0.17)^2 (1+0.17)^3 (1+0.17)^4 (1+0.17)^5 I.e   1.17 0.0289 0.004913 0.00083521 0.000141986 PV -135000 $45,606.60 $2,612.21 $730.74 $179.54 $43.12 Total PV/NPV $49,172 ($85,828)         Incremental operating net cash flow 49,171.00 Appendix 2 Incremental operating net cash flow Alternative 2 Year 0 1 2 3 4 5   -245000           Sales Revenue   1,000,000.00 1,135,000.00 1,288,225.00 1,462,135.38 1,659,523.65 Advertising   30,000.00 30,000.00 30,000.00 30,000.00 30,000.00 Maintenance   38,750.00 38,750.00 38,750.00 38,750.00 38,750.00 Raw materials   320,000.00 363,200.00 412,232.00 467,883.32 531,047.57 Operating Costs   58,500.00 58,500.00 58,500.00 58,500.00 58,500.00 Other expenses   345,000.00 345,000.00 345,000.00 345,000.00 345,000.00     792,250.00 835,450.00 884,482.00 940,133.32 1,003,297.57 sale of asset at 0 dep value   0.00 0.00 0.00 0.00 25,000.00 net revenue   207,750.00 299,550.00 403,743.00 522,002.06 681,226.08 Tax   62,325.00 89,865.00 121,122.90 156,600.62 204,367.82 net inflows before depreciation   145,425.00 209,685.00 282,620.10 365,401.44 476,858.26 Depreciation   44,000.00 44,000.00 44,000.00 44,000.00 44,000.00 Add back Depreciation tax shield   13,200.00 13,200.00 13,200.00 13,200.00 13,200.00 Net Cash inflows   158,625.00 222,885.00 295,820.10 378,601.44 490,058.26 Add Salvage value   0.00 0.00 0.00 0.00 25,000.00 Operating Net Cash inflows -245000 $158,625 $222,885 $295,820 $378,601 $515,058 Cost of capital   0.17         NPV Factor   (1+0.17)^1 (1+0.17)^2 (1+0.17)^3 (1+0.17)^4 (1+0.17)^5 I.e   1.17 0.0289 0.004913 0.00083521 0.000141986 PV -245000 $185,591.25 $6,441.38 $1,453.36 $316.21 $73.13 Total PV -245000 $193,875         NPV ($51,125) Incremental operating net cash flow $193,873 Appendix 3 Appendix 4   Alternative   C.F change   1 2   0 -135000 -245000 110000 1 38980 158625 -119645 2 90388 222885 -132497 3 148736.08 295820.1 -147084 4 214961.1508 378601.4385 -163640 5 290126.6062 472558.2577 -182432     IRR of C.F change 116% Appendix 5 The impact of inflation Incremental operating net cash flow Alternative 2 Year 1 2 3 4 5 Sales Revenue incr by 3.5% 1,000,000.00 1,135,000.00 1,288,225.00 1,462,135.38 1,659,523.65 After inflation 960,000.00 1,089,600.00 1,236,696.00 1,403,649.96 1,593,142.70 Advertising inc by 4% 31,200.00 32,448.00 33,745.92 35,095.76 36,499.59 Maintenance incr by 3.5% 38,750.00 38,750.00 38,750.00 38,750.00 38,750.00 Maintenance incr by 3.5% 40,106.25 40,106.25 40,106.25 40,106.25 40,106.25 Raw materials incr by 3.5% 320,000.00 363,200.00 412,232.00 467,883.32 531,047.57 Raw materials incr by 3.5% 331,200.00 375,912.00 426,660.12 484,259.24 549,634.23 Operating Costs incr by 3.5% 58,500.00 58,500.00 58,500.00 58,500.00 58,500.00 Operating Costs incr by 3.5% 60,547.50 60,547.50 60,547.50 60,547.50 60,547.50 Other expenses incr by 3.5% 345,000.00 345,000.00 345,000.00 345,000.00 345,000.00 Other expenses incr by 3.5% 357,075.00 357,075.00 357,075.00 357,075.00 357,075.00 net revenue 139,871.25 223,511.25 318,561.21 426,566.22 549,280.13 Tax 41,961.38 67,053.38 95,568.36 127,969.87 164,784.04 net inflows before depreciation 97,909.88 156,457.88 222,992.85 298,596.35 384,496.09 Depreciation 44,000.00 44,000.00 44,000.00 44,000.00 44,000.00 Add back Depreciation tax shield 13,200.00 13,200.00 13,200.00 13,200.00 13,200.00 Net Cash inflows 111,109.88 169,657.88 236,192.85 311,796.35 397,696.09 Add Salvage value 0.00 0.00 0.00 0.00 25,000.00 Incremental Operating Net Cash inflows $111,110 $169,658 $236,193 $311,796 $422,696 Appendix 6 Impact of Inflation on cash flows Alternative 1 Year 0 1 2 3 4 5 Sales Revenue 1.135 800,000.00 800,000.00 800,000.00 800,000.00 800,000.00 After inflation   768,000.00 768,000.00 768,000.00 768,000.00 768,000.00 Advertising Inc by 4%   31,200.00 32,448.00 33,745.92 35,095.76 36,499.59 Maintenance   42,200.00 42,200.00 42,200.00 42,200.00 42,200.00   4% 43,677.00 43,677.00 43,677.00 43,677.00 43,677.00 Raw materials 32% 256,000.00 256,000.00 256,000.00 256,000.00 256,000.00     264,960.00 264,960.00 264,960.00 264,960.00 264,960.00 Operating Costs   75,000.00 75,000.00 75,000.00 75,000.00 75,000.00     77,625.00 77,625.00 77,625.00 77,625.00 77,625.00 Other expenses   352,000.00 352,000.00 352,000.00 352,000.00 352,000.00     364,320.00 364,320.00 364,320.00 364,320.00 364,320.00 net revenue   -13,782.00 -15,030.00 -16,327.92 -17,677.76 -19,081.59 Tax     0.00 0.00 0.00 0.00 net inflows before depreciation   -13,782.00 -15,030.00 -16,327.92 -17,677.76 -19,081.59 Depreciation   25,400.00 25,400.00 25,400.00 25,400.00 25,400.00 Add back Depreciation tax shield   7,620.00 7,620.00 7,620.00 7,620.00 7,620.00 Net Cash inflows   -6,162.00 -7,410.00 -8,707.92 -10,057.76 -11,461.59 Add Salvage value   0.00 0.00 0.00 0.00 8,000.00 Incremental Operating Net Cash inflows   ($6,162) ($7,410) ($8,708) ($10,058) ($3,462) Cost of capital 0.17           NPV Factor   (1+0.17)^1 (1+0.17)^2 (1+0.17)^3 (1+0.17)^4 (1+0.17)^5 I.e   1.17 0.0289 0.004913 0.00083521 0.000141986 PV   ($7,209.54) ($214.15) ($42.78) ($8.40) ($0.49) Total PV/NPV ($7,475) ($142,475)         Appendix 7 WACC Source of capital Book Value Market value AT costs Long-term debt $4,000,000 $3,840,000 6% Preference share capital $40,000 $60,000 13% Ordinary share equity $1,060,000 $3,000,000 17%         Ce $1,060,000 $3,000,000   Ps $40,000 $60,000   Cd $4,000,000 $3,840,000     $5,100,000 $6,900,000                   WCe 0.207843137 0.434782609   Wps 0.007843137 0.008695652   Wd 0.784313725 0.556521739   prove 1 1           Tax o.3     1-T 0.7             WACC Wdrd(1-T)+Wps*rps+Wce*rs     Wd*rd(1-T) 0.032941176 0.023373913   Wps*rp 0.001019608 0.001130435   Wce*rs 0.035333333 0.073913043     0.069294118 0.098417391   %(WACC) 6.929411765 9.84173913   Appendix 8 Tax on gain on disposal   book value 135000 depreciation 127000 salvage value 8000   16000 Tax on gain on disposal 4800 Appendix 9 Tax on gain on disposal 2   book value 245000 depreciation 220000 salvage value 8000   33000 Tax on gain on disposal 9900 Appendix 10 IRR Alternative 1   year Cash flow 0 -135000 1 38980 2 90388 3 148736.1 4 214961.2 5 290126.6     IRR 68% Appendix 11 IRR alternative 2   year Cash flow 0 -245000 1 158625 2 222885 3 295820.1 4 378601.4385 5 472558.2577     IRR 87% Appendix 12 PI alternative 1 PI=(NPV+Initial invest)/initial inv (alternative 1)   initial investment 135000 NPV 49171.42   184171.4 PI 1.364233 Appendix 13 PI=(NPV+Initial invest)/initial inv (alternative 2)   initial investment 245000 NPV 193872.8485   438872.8485 PI 1.791317749 Appendix 14 Depreciation per annum = ( Cost   −   Residual Value )   Useful Life    Alternative 1       Cost of machine 135000 135000 Residue Value 8000   Useful life   5   Cost-Residue   127000   Depreciation   25400   Appendix 15 Depreciation Alternative 2   Cost 245000 Residue value 25000 Useful life 5 Cost-R.V 220000 Depreciation 44000 Read More