CF/Jan 10/1

Question 1

Roger Davis the newly appointed financial analyst at Engineering Products Plc is tasked with providing the recommendations on the investment involving a new computer numerically controlled (CNC) milling machine. After meeting with key stakeholders of the project, Davis has gathered information that will be relevant in the recommendation process. Firstly, the initial capital outlay for the new CNC machine is 240,000. The MD mentioned only if the project can pay for itself in 3 years will he consider taking it. This statement reflects the MD desire in using the Payback method as the investment decision criteria. It is assumed that the CNC machine will not be in operation for more than 4 years and will have no other use after that. Based on this, sales will be generated for 4 years only. The machine is depreciated over 6 years on the straight line depreciation method with a depreciation rate of 40,000/year. However, since the machine will only be used for 4 years, then depreciation should also be for 4 years. The new depreciation rate is 240,000/4 years = 60,000/year. The machine will then be sold off in Year 5 for a scrap value of 20,000. The opening stock in Year 1 would be acquired at the same time as the new machine. Therefore this investment in working capital will be included in the cash flow of Year 0. All other stock movement will occur at the end of year. A key principal is if working capital reduces it will be treated as a cash inflow, while an increase will be treated as a cash outflow. The revised working capital movement and changes are as following:Year01234

Beginning Stock 040808060

Ending Stock408080600

Change in Stock Balance40400-20-60

Changes in Working Capital-40-4002060

The profitability forecast by the accountant includes administrative overheads. The other production costs are also apportioned fixed overheads at 20% of labour costs. These amounts have to be removed in the cash flow analysis. Since the overheads were not incurred as a result of this proposal then they are considered as sunk costs. After removing the overhead costs, the category was renamed direct expenses and is calculated as following:Year1234

Other production expenses80.0090.0092.00100.00

Labour costs80.00120.00120.0080.00

Apportioned overhead costs (20% of labour costs)16.0024.0024.0016.00

Direct production expenses64.0066.0068.0084.00

The profitability forecast by the accountant includes the cost for the payment of interest on loans. This is already factored into the rate of return (opportunity cost of capital) and will not be needed in the cash flow analysis. The rate of return for this project is 10%. Based on the production managers assessment when the new machine is installed and existing machine sold off immediately there will be an annual cash inflow of 18,000. The existing machine can be sold at 20,000. This annual cash will be added in the cash flow analysis. This is the preferred option going forward with the cash flow analysis.The current book value of the existing machine is 50,000. This will not be included in the cash flow analysis. If the existing machine is not sold off immediately, it can be kept operating for another 4 years after which it will can disposed of for a scrap value of 8,000. This option has been ignored as it will lead to a negative NPV value. Based on information from marketing there will be an initial expenditure of 40,000 for additional advertising at the start of the project. This expenditure will be included in the cash flow analysis as part of the initial capital outlay. The annual marketing expenditure of 8,000 will be deducted from the cash flow analysis. However, the bill of 18,000 for the external marketing consultants will be considered as sunk cost.

The marketing director mentioned there will be an incidental effect from the new product. This will need to be included in the cash flow analysis. With the gross profit margin at 25% and corporate tax rate at 30%, the cash reduction amount is 60,000 x 0.25 x (1 0.30) = 10,500.The Return on Asset (ROA) showed 16% on the division accounts. This can be considered the internal hurdle rate.Question 2

The return on asset is the accounting rate of return as it reflects tax and accounting figures. In some cases cash outflows are classified as either an operating expense in the income statement or as a capital investment in the balance sheet and depreciated. Therefore the book rate of return depends on which cash flow is classified as a capital expenditure and how rapidly they are depreciated. It doesnt reflect market values or cash flow.The Payback method is set at 3 years. The payback period is the time by when the initial outlay of the project is equals the cumulative forecasted cash flow. The main drawbacks with this method is that it can be quite misleading as it ignores all cash flows after the cut off date. We can be in a situation where a project might not meet the cut off point, but sees very large cash inflows after that point. This goes to show that in many cases, the cut off dates were arbitrarily chosen. Furthermore, this method ignores the time value of money. Moving on its advisable to start looking at the discounted cash flow (DCF) methods such as the Internal Rate of Return (IRR) and Net Present Value (NPV). IRR is basically the rate of discount that makes NPV equals 0. For IRR the rule to accept an investment is IRR must be bigger than the opportunity cost of capital. With Payback and ROA considered to be ad-hoc measures, the DCF methods have higher acceptance and respectability. However, the IRR method does have a number of drawbacks that will end up affecting the decision making for an investment. The main drawback is the unreliability in ranking projects of different scale and projects which offer different patterns of cash flow over time. Due to the drawbacks of IRR, the NPV method has greater prominence in the financial analysis of investments. When using NPV its important to ensure that both the technique and cash flow forecasts are as accurate as possible. The basic rule that is applied for NPV that when the overall summed value is positive it indicates that the project is worth more than it costs. In other words, it means that the investors wealth can be maximized by accepting a project with a positive NPV. Therefore, the NPV method will also be used as the basis for the evaluation and selection of this project.Period (Year)01234

('000s)('000s)('000s)('000s)('000s)

Capital investment240.00

Accumulated depreciation60.00120.00180.00240.00

Year end book value240.00180.00120.0060.000.00

Working capital40.0040.0020.00-40.00

Total book value240.00220.00160.0080.00-40.00

Sales400.00600.00800.00600.00

Cost of sales220.00300.00380.00300.00

Labour80.00120.00120.0080.00

Direct production expenses64.0066.0068.0084.00

Depreciation60.0060.0060.0060.00

Pre-tax profit-24.0054.00172.0076.00

Tax at 30%-7.2016.2051.6022.80

Profit after tax-16.8037.80120.4053.20

Period (Year)012345

('000s)('000s)('000s)('000s)('000s)('000s)

Initial capital outlay -240.00

Sales400.00600.00800.00600.00

Cost of sales220.00300.00380.00300.00

Labour80.00120.00120.0080.00

Direct production expenses64.0066.0068.0084.00

Tax at 30%0.00-7.2016.2051.6022.80

Operation cash flow0.0043.2097.80180.40113.20

Changes in working capital-40.00-40.000.0020.0060.00

Disposal proceeds of existing machine (less 30% tax)14.00

Cash benefits of disposing existing machine18.0018.0018.0018.00

Marketing expenditure-40.00-8.00-8.00-8.00-8.00

Reduction in sales (less 30% tax)-10.50-10.50-10.50-10.50

Disposal proceeds of CNC machine (less 30% tax)14.00

Net Cash Flow-306.002.7097.30199.90172.7014.00

Tax rate30%

Cost of capital10%

NPV53.70

IRR15.9%

Looking at the net cash flow of the cash flow analysis above the payback point is 3.04 years from the start of operations. Based on the cash flow analysis done above which assumes straight line depreciation, it shows that the NPV has a positive value and the IRR value is above the cost of capital. Therefore, if this project is taken up then the initial capital outlay will experience a growth in value resulting in the increase of shareholders wealth.

Question 3

In reality most companies will have constraints on capital which results in the situation where not every positive NPV project can be taken up. If investment capital is constrained in one particular period, then the Profitability Index (PI) should be used as the basis for selecting the most financially viable project. The PI is the ratio of present value of future cash flows against the initial investment and must be above 1 for a project to be accepted. In the case of this project, the PI based on the straight-line depreciation method is as following:

Investment

('000s)NPV

('000s)PV (Year 1 4)

('000s)Profitability Index

(PI)

306.0053.70359.701.175

The PI of 1.175 indicates the sum of the PV of the future cash flows is higher than the initial investment. The idea here is to ensure that the PI for this project is higher than the PI of other planned investments by the company. Since neither the NPV nor the PI of other projects are provided for this assignment, we can go by the argument that if the PI of this project is higher than the other planned projects it should be accepted. Question 4Strategic planning is a key component of capital budgeting which is a top down view of the company. One key aspect of strategic planning in determining the viability of a project is subjecting the said project to a sensitivity and scenario analysis. What happens here is that key variables that can have an effect on the projects NPV are subjected to variances in order to analyse its outcome. In the case of this proposal the key variables that can be analyzed are the sales revenue, cost of sales, cost of labour, direct production cost, incidental effects (cash reduction) and marketing cost. Sensitivity Variables

Change factor for a minimum NPV > 0 (%)

SalesDecrease by 4%

Cost of salesIncrease by 8%

LabourIncrease by 24%

Direct production costIncrease by 34.5%

Incidental effect (cash reduction)Increase by 160%

Marketing costIncrease by 82%

Based on a series of sensitivity tests on these key variables, it was observed that sales revenue was the most critical in maintaining a positive NPV. Therefore additional emphasis must be given in growing and maintaining sales. This can be coincided with additional marketing expenditure which is another key sensitivity variable.It is also important to be vigilant with the cost of sales as it can significantly affect the project cash flow. Since this cost element is largely affected by the cost of raw material, detailed planning must be done prior to purchasing. It is also vital to understand market pricing trends of the raw material mainly steel in order to get optimum pricing during actual purchasing.

However, it is more realistic and important to look at the analysis of scenarios. Scenario analysis is based on multiple sensitivities of interconnected variables done concurrently that are based on a number of plausible scenarios.In Scenario 1, there is a 10% increase in operating expenditure such as cost of sales, cost of labour and direct production cost. The incidental effect remains the same but as a result of the cost increases; marketing expenditure was reduced by 15%.

Sensitivity Variables

Scenario 1

Cost of salesIncrease by 10%

LabourIncrease by 10%

Direct production costIncrease by 10%

Incidental effect (cash reduction)Unchanged

Marketing costReduced by 15%

SalesIncrease by 7.14%

Therefore, in order to maintain the NPV as before, there has to be a sales growth of 7.14%. In Scenario 2, there is a 10% decrease in sales. During this period only the incidental effect remains unchanged. All other costs will have to subject sensitivity tests in order for us to arrive at the current NPV. Sensitivity Variables

Scenario 1

SalesReduced by 10%

Incidental effect (cash reduction)Unchanged

Cost of salesReduced by 10%

Direct production costReduced by 9%

Marketing expenditure Reduced by 10.5%

LabourReduced by 20%

Therefore, in order to maintain the NPV as before, some key variables will be subject to tuning. The cost of sales, direct production cost and marketing expenditure will be reduced by about 10%. However, the bulk of the adjustment will be on the labour cost which sees a reduction of 20%. Since the reduction of sales will result in slower production runs resulting in lower utilization of labour resources. Scenario analysis can be very helpful to look at different sets of variables and how they affect the NPV of a project. It also helps in corporate strategic planning. In conclusion, for the new CNC project the main variable for the success is the sales revenue. Therefore, it is beneficial to increase sales. This can be achieved either by higher volume of sales or by increasing the price per unit of product. The new machine with its flexible technology should result in higher overall productivity and quality. The sensitivity and scenario analysis also indicate that the cost of sales is the most important cost variable followed by labour. The overall profits, cash flow and NPV of this project will also depend largely on how these cost components are effectively managed.Question 5

There is an annual writing down allowance of 25% on the reducing balance which can be claimed for taxation purposes. Based on this, the table below shows the depreciating expense under the reducing balance method:

Period (Year)1234

('000s)('000s)('000s)('000s)

Beginning balance240.00180.00135.00101.25

Depreciation-60.00-45.00-33.75-101.25

Ending180.00135.00101.250.00

Period (Year)01234

('000s)('000s)('000s)('000s)('000s)

Capital investment240.00

Accumulated depreciation60.00105.00138.75240.00

Year end book value240.00180.00135.00101.250.00

Working capital40.0040.0020.00-40.00

Total book value240.00220.00175.00121.25-40.00

Sales400.00600.00800.00600.00

Cost of sales220.00300.00380.00300.00

Labour80.00120.00120.0080.00

Direct production expenses64.0066.0068.0084.00

Depreciation60.0045.0033.75101.25

Pre-tax profit-24.0069.00198.2534.75

Tax at 30%-7.2020.7059.4810.43

Profit after tax-16.8048.30138.7824.33

Period (Year)012345

('000s)('000s)('000s)('000s)('000s)('000s)

Initial capital outlay -240.00

Sales400.00600.00800.00600.00

Cost of sales220.00300.00380.00300.00

Labour80.00120.00120.0080.00

Direct production expenses64.0066.0068.0084.00

Tax at 30%0.00-7.2020.7059.4810.43

Operation cash flow0.0043.2093.30172.53125.58

Changes in working capital-40.00-40.000.0020.0060.00

Disposal proceeds of existing machine (less 30% tax)14.00

Cash benefits of disposing existing machine18.0018.0018.0018.00

Marketing expenditure-40.00-8.00-8.00-8.00-8.00

Reduction in sales (less 30% tax)-10.50-10.50-10.50-10.50

Disposal proceeds of CNC machine (less 30% tax)14.00

Net Cash Flow-306.002.7092.80192.03185.0814.00

Tax rate30%

Cost of capital10%

NPV52.52

IRR15.7%

Based on the analysis done it can observed that a lower NPV value is obtained versus NPV of 53.70 using the straight line method. The PI from the reducing balance method is 1.172 l. The payback point from the cash flow analysis is 3.1 years which is slightly slower than the payback period calculated based the straight line method.

This goes to show with the right set of data, the NPV method is very useful in analysing the viability of an investment project and can be used as the platform for recommending an investment plan to management. Interestingly the IRR for both the methods is very close to 16%, with IRR for the straight line method being marginally higher at 15.9%. This is a good indication as it is above the cost of capital. Recommendation:

Davis should recommend that this project to be accepted. This is because of both the positive NPV and also a PI which bigger than 1. Since the values provided by NPV are more indicative of the health of the projects cash flow and profits, it is the preferred method of analysis. Other analysis methods such as IRR and Payback were also attempted. The IRR values for both methods were higher than the cost of capital and were very close to the hurdle rate. The payback periods were also very close to the expectation of the MD. Furthermore, the strength of the cash flows in the 4th year is another strong supporting factor in accepting this project. To further strengthen the case for this recommendation, the profit projection and cash flow analysis based on the straight line depreciation method should be chosen. It gives the best results for NPV, PI, IRR and Payback.

In conclusion, the positive and promising results from the financial analysis coupled with the embrace of new technology and higher productivity in an attractive and profitable business makes this investment a wise financial and strategic decision. ReferencesBrealey, R., Myers, S., and Allen, F. (2008). Principles of Corporate Finance. 9th Edition. New York: MrGraw-Hill/Irwin.

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