STRATEGIC AND FINANCIAL DECISION-MAKING (ACFI5022)

Assignment 2018/2019

By……………….

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 TABLE OF CONTENTS

Particulars Page No.

Task 1

NPV 3

IRR 3

Factors affecting the capital investment decisions 4

Calculation of NPV and IRR 6

Task 2

Comparison of NPV and payback period 9

Comparison of IRR and accounting rate of return 10

Task 3 11

Task 4 12

Task 5

Benefits of organic growth 13

Benefits of acquisition growth 14

References 15

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 Task 1

NPV

It is the difference between the present value of the cash inflows and the present value of the

cash outflows. It helps to know about the cash profitability over the period of time. The

technique of NPV is being used in capital budgeting and also the planning of the investment in

order to analyze the level of profitability in relation to a particular investment. The positive NPV

shows that the project is profitable and should be accepted and shows that the earnings are more

than the forecasted costs. The negative NPV shows that the project is non-acceptable and the

forecasted costs are more than the earnings of the project. The net present value method basically

calculates the present value of future cash flows. Hence it takes into account the time value of the

money. Hence it will help in comparing the capital projects with different cash flows which are

being earned over a period of time. The calculation of NPV is being done after comparing the

cost that is the cash flows which are negative with the benefits that is the cash flows which are

positive in relation to the specified period of the project. NPV is the sum of all the future cash

flows which are discounted at an appropriate rate.

IRR

The internal rate of return is a method which is used in capital budgeting in order to estimate the

level of profitability of different potential investments. The internal rate of return is the discount

at which the present value of the cash inflows is equal to the present value of cash outflows

hence the NPV calculated by discounting the cash flows at IRR is equal to zero. The calculation

of IRR is basically done using the trial and error method or by using the program designed for

calculating the IRR. The project with the higher internal rate of return is acceptable and it will

provide more profit to the company. The internal rate of return provides uniform results for

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different types of investments hence this can be used as the basis for ranking different potential

investment projects of the company. For example, if the investment initial cost is equal in two or

more potential projects then project with the highest internal rate of return will be desirable in

order to attain high profitability.

The NPV is calculated by discounting the cash flows of the company at WACC.

WACC= Cost of equity*market value of equity/(Market value of equity+ Market value of debt)+

Cost of debt after tax*Market value of debt/(Market value of equity+ Market value of debt)

Cost of equity= Dividend of next year/ Market value of equity+ Growth rate in dividends

Growth rate in dividend= {(Next year dividend/dividend of beginning period)/^1/n}-1 *100

Cost of debt= Interest*(1-tax rate)/ market value of debt

The calculation of the NPV and IRR had been done below. The analysis of the scenario shows

that NPV of the project is positive hence it is acceptable. The IRR in relation to the project is

higher than the cost of capital hence the project will provide profitable returns to the company in

the future period.

Factors affecting the opinion in relation to accepting project or not are as follows:

1. The calculation of the NPV. The NPV of the project is positive hence it is acceptable.

2. The calculation of IRR and the IRR of the project is higher than the cost of capital.

3. The technological changes in relation to the equipment are to be analyzed and the

machinery will be used for 5 years under which it is assumed the machinery will be

equally efficient.

4. The demand forecast is being prepared for 5 years hence it shows that the project will be

profitable for coming 5 years.

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 5. The two launched products will be having highly competitive market and the machinery

is cost effective which will be covering the overall market.

6. The management of the company is new thus it is having the capacity to manage with the

new equipment and machinery.

7. The deep analysis of the project to be undertaken shows that government policies will

remain stable in the coming 5 year period.

8. The NPV schedule had been prepared in accordance with the single taxation rate for the

period of five years hence the taxation policies will also remain stable.

9. The changes in the inflation had also been taken into consideration while calculating the

NPV and IRR.

Thus, the above factors shows that the project is favorable for the company and it should be

accepted by the company.

Calculation of WACC

The calculation of cost of equity is as under:

Particulars Amount

Calculation of growth rate

Difference between beginning and ending = 655875-375000

period dividend =280875

Growth rate = {(280875/375000)^(1/4)-1}*100

= 15%

Cost of equity = 655875/(3000000*5.2)+15%

= 15.04%

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The calculation of cost of debt is as under:

Particulars Amount

Interest rate 6%

Tax rate 25%

Market price of bond 110

Cost of debt after tax = 6(1-0.25)/110

= 4.09%

The calculation of WACC is as under:

Particulars Amount

Cost of equity 15.04%

Market value of equity = 3000000 x 5.2

= 15600000

Cost of debt 4.09%

Market value of debt =5000000/100 x110

= 5500000

WACC = 15.04 x 15600000/(15600000+5500000)+

4.09 x 5500000/(5500000+15600000)

WACC 12.18%

Calculation of NPV

Year 2019 2020 2021 2022 2023 2024

Cost of -          

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machinery 6000000

Blaster units   60000 110000 100000 30000  

Selling price   30.98 31.91 32.87 33.85  

Sale value   1858800 3510034 3286668 1015580  

Hounddog   75000 137500 125000 375000 68750

Selling price   23.12 23.81 24.53 25.26 26.02

Sale value   1734000 3274370 3066001 9473943 1788996

Direct material

cost per unit

Blaster   12.00 12.48 12.98 13.50  

Direct mater cost

of Blaster   720000 1372800 1297920 404951  

Direct material

cost per unit

Hounddog   9.00 9.36 9.73 10.12 10.53

Direct material

cost of Hounddog   675,000 1,287,000 1,216,800 3,796,416 723,850

Net contribution

from both models   2197800 4124604 3837949 6288157 1065146

Fixed production

costs   999750 1049738 1102224 1157336 1215202

Cost of

advertising   500000 200000 200000 200000 200000

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 Depreciation   1200000 1200000 1200000 1200000 1200000

Net profit before

tax   -501950 1674867 1335725 3730821 -1550056

Net profit after

tax   -376463 1256150 1001794 2798116 -1162542

Net cash flow 6000000 823538 2456150 2201794 3998116 37458

PV factor

(12.18%) 1 0.891 0.795 0.708 0.631 0.563

Present value of -

cash flows 6000000 734122 1951749 1559661 2524606 21085

NPV 791223          

Note:

The value of the production overhead is being calculated using the forecasted units of 2020

The depreciation is being charged assuming that the machinery is being depreciated equally in

five years.

Calculation of fixed cost= (8.65*60000) + (6.41*75000)= 999750

The selling price, direct material cost and the fixed cost had been increased in accordance with

the rate of inflation.

Calculation of IRR

Particulars Amount

Assuming two discount rate 14% and 22%

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 NPV at 14% 485137

NPV at 22% (643626)

IRR = 14+(485137*(22-14)/(485137+643626)

= 17.4%

Task 2

Comparison of the NPV method and the payback period method

The net present value provides the value in relation to the respective currency but the payback

period provides the time period in which the returns from the project will be able to cover up the

initial cost of the investment. The net present value takes into account the time value of money,

level of inflation and the level of risk while computing the cash inflows. On the other hand the

payback period method does not take into consideration the time value of money. The payback

method does not take into account the profits and cash inflows that are obtained after the

payback period thus it does not provide measurement of the total income. The payback period

provides the minimum period which is acceptable for the project on the other hand the net

present value method calculates the benefits that will be received by the company in the terms of

dollar. Hence the net present value method takes into account the cash flows that are achieved till

the end of the project. The value of NPV equates the total of the present value of cash inflows

and cash outflows. The value of payback period is equal to the cost of project divided by the

annual cash flows or the savings in cost. The decision in relation to accepting the project or

rejecting the project is taken on the basis of the highest NPV when NPV is used as the basis of

the decision. The project which is having shorter payback period will be accepted as the project

with longer payback period shows that the funds are being locked in the project for a longer time

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and will not provide adequate returns on the project. Hence the long payback period can also

make the project unsustainable.

Hence the above analysis shows that the net present value method will provide better results in

comparison to the payback period when the capital investment decisions are to be taken. The sole

reliability on the payback period method for the capital decisions can lead to situation of poor

and improper financial decisions.

Comparison of IRR and accounting rate of return

The internal rate of return is the method which helps in reducing the difference between the

present value of cash inflows and present value of cash outflows to zero. The internal rate of

return is basically the rate of return which is expected to be generated by the project over the life

of the project. On the other hand the accounting rate of return is calculated as the annual returns

generated from the project divided by the book value of the project or investment. The annual

returns are the annual profits that are generated from the project. The annual profits are

computed by deducting the depreciation from the annual cash flows. The IRR method provides

that the project is desirable if the internal rate of return is higher than the cost of capital

applicable on the company. The internal rate of return is a method which discounts the cash

flow; hence it takes into account the time value of the money. The accounting rate of return does

not discount the cash flow hence it does not take into consideration the time value of money.

Thus the IRR also shows the changes in the cash flows of the project over the period of time

whereas the accounting rate of return shows that the value of the cash flows in the future from

the project does not change over the period of time. Thus ARR does not recognize the potential

of the project to invest and the increase in its value over the specified years. The decision is

taken on the basis of the IRR by comparing it with the cost of capital. The decision is taken on

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the basis of accounting rate of return by comparing it with the criteria of decision which is being

set by the management. Thus the comparison shows that IRR shows the realistic results by taking

into account the present value factors. The accounting rate of return may also give biased results

as the decision criteria set for accounting rate of return may not be appropriate and can be

influenced by the personal goals of management.

Thus, the comment of Beverly Sparkes in relation to use of the payback period method and

accounting rate of return for appraising the project is not a reliable method.

Task 3

Comment of Hickson to increase the proportion of debt in the capital structure.

Capital structure had become an important part in the corporate finance. The objective of every

company is to maximize the level of profits and also give maximum returns to different

shareholders of the company. Thus, the company needs to maintain appropriate and optimum

capital structure in order to achieve the targets which are set by the company. The weighted

average cost of capital of the company is linked with the debt and equity ratio of the company.

The tax benefit and shield are being provided on the debt funds. The use of the debt funds in the

capital structure of the company helps in acting as the device for monitoring and thus the debt

funds will be putting pressure on the managers of the company to improve the performance of

the company so that the company is having enough cash to pay off the interest and debt. The

company needs to invest their money in the projects provides the return which is more than the

cost of funds that is the cost of capital.

According to Myers and Majluf (1984), the use of the debt in the capital structure in the

company will help in reducing the problems of agency in the company. The rate of interest to be

paid on debt is fixed irrespective of the level of profits. The level of the earnings of the company

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increases with the increase in debt as the interest rate is fixed. The profits available after the

payment of fixed interest cost will provide high level of surplus funds for the shareholders of

equity. Thus, it will help in increasing the EPS of the company. The interest that is paid on the

debt funds is a charge against the profits and thus it will also help in reducing the level of tax

liability.

Thus, in accordance with the analysis, I agree with the comment of Hickson that it would be

better to use more debts and corporate bonds in the business as the use of debts will provide the

tax benefits to the company. The WACC of the company also decreases if the cost of debt is less

than the cost of equity. Hence the company should increase the proportion of the debts in the

company as the cost of equity is very higher and hence thus the increase in debts will lead to

increase in the debt equity ratio. Hence the overall WACC of the company will also decrease and

will provide high returns to the company.

Task 4

The capital asset pricing model helps in creating the relationship between the return expected

from the project and the risk that is associated with the investment in the project. There are

various assumptions that are being held in the calculation of CAPM which are the investors are

interested in holding the diversified portfolio, the horizon of the transaction is single period,

investors are ready to lend and borrow at the risk free rate of interest and also assumes that all

the securities are correctly valued and it is a capital market of perfect nature.

The CAPM is only focusing on the relationship between the systematic risk and the return from

the security. The assumptions which are being made by CAPM model are unrealistic and do not

exist in real scenario. The capital markets in the real situations are not perfect. The securities are

not correctly priced. It also holds the assumption that the investors are holding diversified

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portfolio but none of portfolio can cover all the securities as a whole. The other problem in the

CAPM model is that investors are not able to borrow funds at the risk-free rate.

Hence it is not appropriate to use CAPM in the calculation of WACC as CAPM model assumes

that the beta of debt is zero and it can lead to inaccuracy in the calculation of discount rate. The

CAPM model assumes that the horizon of investment is single period whereas the investments

for which appraisal are to be given are multi-period. It is very difficult to calculate the beta

which is related with the investment as the accurate assessment of project is very difficult. The

problem also arises when the market returns are negative and the market provides analysis of

previous return not the future returns. Hence the CAPM model should not be used in WACC.

Task 5

Critical analysis of the relative benefits of two organic growth and acquisition growth from the

point of view of Eden

The benefits of organic growth are:

1. It will help Eden in maintaining the current style of management, culture and level of

ethics in the business.

2. There is low level of risk in comparison to the external growth such as merger and

acquisition as company can expand in its specialization and sound areas.

3. The financing can be done using the internal funds such as the profits which are retained

in the business.

4. It helps in building the existing strength such as the loyalty of the customers and brand of

the company.

5. It is easy to control the operations of the business.

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 6. It also helps in maintaining high level of efficiency, productivity and morale of

employees.

7. It helps in the growth of the business at the sensible rate in the long term period.

The benefits of acquisition are as follows:

1. It will help in merging the level of control and power that they hold over the market.

2. It will help in taking the benefit of synergy that is the increasing the level of efficiency

and also increasing the savings in cost and returns.

3. It also helps in taking the benefit of the economies of scale by sharing the resources and

the manpower.

4. It provides benefit of reducing risk by using the innovative techniques for the

management of risk

5. It provides a pool of technological developments and thus helps in maintaining the

competitive position.

6. It will help in providing tax benefits as the tax shields are provided with increase in

leverage position.

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