ACC00716 Finance for Capital Budgeting and The Conveyer System

You are helping Initech with its capital budgeting decisions. The company is a producer and wholesaler of electronic parts, has a 14% cost of capital and is subject to a 30% tax rate. There are two major proposals on which Initech would like your advice.

Initech is considering whether it should expand into production of a part for a new generation of mobile devices. Trends suggest these devices and their parts will offer high growth in the early years of a 5-year life cycle.

The new plant and equipment needed to produce the part will cost $800,000, which the business will depreciate for tax purposes using a prime cost rate of 10% per annum. When the project is wound up at the end of five years, the general purpose equipment is expected to be sold for an estimated $200,000.

Sales in the first year are expected to be $4,000,000, increasing at a high rate of 10% in the second and third years and then falling by 15% per year for the last two years of the project as demand declines due to competing new technologies. Consultants called in previously by Initech, who were paid $75,000 in fees, estimated that variable costs for the project will be 50% of its revenues.

Building rental, fixed salaries and other fixed costs directly related to the project are expected to be $1,500,000 in the first year and increase by 2% per year thereafter. The investment in net operating working capital related to the project is expected to be 10% of the following year’s sales revenues. This investment will be recovered by the end of the project. It is also thought that the project will encourage additional after
tax profits of $150,000 per year for Initechs’ existing part range.

Initech needs to install a conveyer system as soon as possible because the existing system, which has no scrap value, is beyond repair. Three different systems are being considered. The first, System A, is the same type of system as the old one – just a newer model. It will last 10 years and cost $40,000 to purchase and install. The second, System B, will last 10 years and cost $55,000 to purchase and install. The third, System C, will
last 20 years and cost $130,000 to purchase and install. None of the systems will have any expected salvage value but all will be replaced at the end of their lives. After examining all costs, the net cash outflows for each system are: $13,000 per year for System A; $9,000 per year for System B; and $1,400 per year for System C.

For this question you are required to further analyse the ASX listed company assigned to you for Assignment.

a) Briefly describe a likely “average” risk capital budgeting project for the company. Consider its possible life, cash flow pattern and investment size relative to the company. Also hypothesise the variables to which NPV might be most sensitive and would therefore need the most focus in project analysis. No quantitative analysis is needed to answer this question. Focus on qualitative factors. If the company has several business
divisions, choose one for this question. 

b) Assess the working capital management of your assigned company, focusing on its cash conversion cycle for each of the 30 June 2015 and 30 June 2016 financial years. Incorporate the company’s context within your evaluation and compare with a competitor or other relevant benchmark. As in Assignment, use DatAnalysis to access your assigned company’s financial data.

No additional research or data is necessary in answering this question. Simply apply your knowledge from the unit learning materials. In its 2016 Annual Report, Telstra Corporation Limited stated that (p. 112):

Our commercial paper is used principally to support working capital and short term liquidity.

a) What does the use of commercial paper suggest about the credit risk of Telstra? 
b) What asset financing policy does the quote above suggest Telstra may follow? Justify your answer and outline the benefits of that policy in comparison with alternative policies.

Device part project - Production of new generation mobile device parts in the existing production (expansion of production unit)

The necessary information regarding the project is outlined below:

• New plant and equipment

Total economic life of project is 5 years and the initial cost which covers installation as well amounts to $800,000. Various fixed cost of the project is $1,500,000. The amount would increase annually with a rate of 2% p.a. The salvage value of the new plant and equipment is $200,000 that would be received from the liquidation of the plant and equipment. The variable cost would be fifty percent of the derived revenue.

• Consultant fee

Fee has been paid to the consultant before the execution of the project. The amount is $75,000. This amount would be sunk cost for the project and hence, would not considered in the capital budgeting analysis that follows (Titman et. al., 2016).

• Various revenues

These plant and equipment would be sold after the completion of the device part project and would generate revenue of $200,000. In the very first year of the project (means at t = 1) the total revenue generated is $4,000,000. The investment amount in the new operating working capital would be 10% of the next year’s revenue. The amount of additional profit after the tax liability is $150,000 per annum.

• Depreciation and book value

This plant and equipment would be depreciated at a rate of 10% per annum. The total accumulated depreciation would be calculated as. The book value of the new plant and equipment after the five year of the project would be determined as

• Loss from the sale

The plant and equipment is sold at a lower price than the book value. Hence, the loss would be computed as = (Ross, Trayler and Bird, 2007).

• After tax salvage vale

The sum of income received from the liquidation of the new plant and equipment and the tax benefits received for the loss incurred from the sale. The value is determined as= (Damodaran, 2010).

• Assumption for the computation of NPV

The cash inflows and outflows are in the lump sum payments only and incurred at the end of the year. Further, the Initech would liquidate the acquired new plant and equipment once the project life is over

• NPV computation

The net present value NPV has been determined in the excel spreadsheet and the final table of the result is shown below:

• Value of NPV = $983,262 (positive)

• Recommendation

As the value of net present value (NPV) is positive that indicates that the project is beneficial to the company because it would produce positive cash flows. Therefore, it is recommended that company should adopt the proposal to produce new generation mobile device parts (Brealey, Myers and Allen, 2012).

Proposal 2

Conveyor System - Company has three different conveyor system options (A, B and C) to replace the current one. Selection of suitable conveyor system for the Initech Company.

The necessary information regarding the project is outlined below:

• Economic life of the systems

System A and B is having an economic life of 10 years while the system C is having an economic life of 20 years.

• Total cost

Cost related to the system A is $40,000 and $55,000 for system B. This cost is $130,000 for system C.

• Annual cash flow

System A would result a net cash flow of -$13,000 and the amount is -$9,000 for system B. The annual cash flow for system C is $-1,400.

From the information it is apparent that the economic life is different and hence, NPV concept would not use for the selection of appropriate conveyor system. Therefore, equivalent annual annuity would be taken into account. The system which has maximum equivalent annual annuity would be considered the most suitable conveyor system for the company (Titman et. al., 2016).

The appropriate choice to replace the current dysfunctional conveyer system would be conveyer A as out of all the above options that have been evaluated, it is system A which leads to minimal financial costs for the company (Damodaran, 2010).

2. a) The company is involved in the furniture business and thereby a typical project could be setting up a new store for furniture. The various aspects related to the project are as follows.

Life of the project = 8 to 10 years although termination may be required earlier

Typical investment - $ 5 - $ 7 million (including working capital)

The store would be leased with a down-payment coupled with monthly lease rentals.

Nature of Cash Flows – Before opening, the cash flows would be heavily negative considering the capital costs involved in making the place furnished. Further, after opening in the initial months, positive cash flows would not occur due to high operating expenses and hence 4-6 month working capital would be included in the outlay of the project. After some months, the operational cash flow may turn to be positive.

Factors on which NPV depends: Location as it impacts generation of Revenue, Cost of Capital, Timing of Cash Flows, Expenses Control, Economic Scenario

Highly Critical factors would include location, cost of capital and economic scenario.

b) The company selected is NCK or Nick Scali Limited and the relevant competitor has been Fantastic Holdings Limited or FAN. The relevant data regarding cash conversion cycle is captured as shown below.

It is apparent from the above data, that NCK tends to underperform when it comes of working capital management. The area of concern for NCK is the large inventory turnover period which is hurting the company but as apparent from the decrease in inventory turnover period in FY2016, the company is improving in this regard. This is the major difference for the two companies and NCK has immense scope of improvement. However, the encouraging trend for NCK is that it has managed to decrease the overall cash conversion cycle by a higher number of days in comparison to competition. A lower cash conversion cycle is preferable since it implies lower need of working capital on the part of the company (Damodaran, 2007).

Telstra follows a maturity matching policy which becomes apparent from the quote where it is clearly stated that commercial paper is used only for working capital funding which implies that for long term financial needs, probably term loans, bonds or equity would be used as appropriate financing means because of their longer tenure. 

References

Brealey, R.A., Myers, S.C. and Allen, F. (2012) Principles of corporate finance. 2nd edn. New York: McGraw-Hill Inc.,US.

Damodaran, A. (2010) Applied corporate finance: A user’s manual. 3rd edn. New York: Wiley, John & Sons.

Ross, S.A., Trayler, R. and Bird, R. (2007) Essentials of corporate finance. Sydney, Australia: McGraw-Hill Australia.

Titman, S, Martin, T, Keown, AJ & Martin, JD (2016), Financial management: principles and applications, 7th edn, Victoria: Pearson Australia