ACC511 Financial Statement Analysis -Free samples to Students

Introduction

The key observations about RWE Enterprises Pty Ltd based on the given information and data are highlighted below:

• RWE is a small manufacturing firm situated in Brisbane.
• RWE has decided to setup a new plant unit.
• The upfront cost of the new plant unit would be $3 million.
• The expected total life of the new plant would be 10 years.
• The new plant would have an after tax scrap value of $200, 000 at the end of 10th year.
• The company has estimated that the new plant would be able to generate an after tax profit of $700,000 each year during its service life.
• There is one time refurbishment cost of $2 million associated with the new plant which would be incurred at the end of 5th year of its total service life.

Analysis

• Based on the above information, it can be said that depreciation is a key element that needs to be taken into consideration in regards to determine the cash flows from the new project. Further, the depreciation needs to be subtracted every year to arrive at the after tax profit of $700,000.

However, it is essential to note that depreciation is considered as a non-cash expense and therefore, it is pivotal to first subtract the depreciation amount and then add back in order to balance the computation (Damodaran, 2015).

It is noteworthy that one time refurbishment cost of the plant i.e. $2 million that would be incurred at the end of 5 years would also be added to the depreciation amount in the later years since this cost would be essentially capital costs only (Lasher, 2017).

Therefore, in regards to the depreciation amount, the final conclusion can be represented below:

The estimated project cash-flows over the ten year project life is estimated below.

• NPC Criterion: In this case, RWE Enterprises Pty Ltd has decided to use a discount rate of 10%. With the help of inbuilt NPV function of excel, the NPV has been calculated and the value comes out to be $2.8 million. It can be seen that the NPV is positive (higher than zero). Therefore, the conclusion can be made based on the positive NPV value that it would be profitable for the firm to purchase the new production line (Petty et. al., 2015).

• IRR Criterion: By taking the project cash flow and by using excel inbuilt function of IRR computation, the internal rate of return (IRR) has been calculated and comes out to be 27.25%. According to the decision rule, the project would be considered as profitable project when the IRR of the project comes out to be greater than firm’s discount rate. In this case, it can be seen that IRR is higher than firm’s discount rate (27.25% > 10%) and hence, RWE Enterprises Pty Ltd should purchase the new production line (Parrino and Kidwell, 2014).

PI Criteria: The profitability index of the project comes out to be 1.93. It is the indication of the fact that firm is able to manage the hurdle rate of 1 and hence based on profitability index criteria, it would be profitable for the firm to purchase the new production line (Northington, 2015).

It can be seen that the service life of the new production plant is 10 years and the payback period comes out to be 3.06 years. It is apparent that pay-back period is lower than the service life of the project. It means the firm can recover the cost of the project within a period of 3.06 years and hence, it would be profitable for RWE Enterprises Pty Ltd to setup the new production line (Brealey, Myers and Allen, 2014).

It can be concluded based on the above analysis that all the requisite criterion indicate that RWE Enterprises Pty Ltd should setup the new production line at the earliest since it would be in the interest of shareholders of the company and enhance the value of the company by an estimated amount of $2.8 million.

1. The key concern in the given case is to carry an evaluation of the two projects based on the expected cashflows that have been provided. Also, for computation the discount rate for each of the projects has been given as 12% p.a. The NPV, IRR and payback period have been computed using the inbuilt functions (NPV, IRR) in excel. The respective values that have been achieved for Project A are as follows.

The corresponding computations have also been performed for Project B based on the estimated cash flow information over the project duration using the inbuilt functions (NPV, IRR) in excel. The respective values that have been achieved for Project B are as follows.

1. Having determined the key capital budgeting parameters for the two projects, it is essential to comment on the acceptability of each of the two products considering the evaluation norms for capital budgeting parameters coupled with the management requirements.

Project A Evaluation

• Net Present Value (NPV) - For achieving financial feasibility, the project must ensure that the project NPV is positive. The NPV of the project is indicative of the impact on the value of the firm. Hence, a positive NPV would enhance the firm value and create wealth for shareholders. Project A has a positive NPV and thereby it is acceptable (Lasher, 2017).

• Internal Rate of Return (IRR) - For achieving financial feasibility, the project must ensure that the project IRR exceeds the discount rate. The underlying rationale is that at discount rate being equal to IRR, the NPV is zero. Hence, if the project discount rate is lower than IRR, then NPV would be positive and hence wealth would be created for shareholders. Project A has an IRR which exceeds the project discount rate and thereby it is acceptable (Damodarann, 2015).

• Payback Period – The company has defined the criterion that projects with payback period in excess of 3 years would be rejected. Project A has a payback period which does exceed 3 and hence it fails on this criterion implying its rejection (Brealey, Myers and Allen, 2014).

Project B Evaluation

• Net Present Value (NPV) - For achieving financial feasibility, the project must ensure that the project NPV is positive. The NPV of the project is indicative of the impact on the value of the firm. Hence, a positive NPV would enhance the firm value and create wealth for shareholders. Project B has a positive NPV and thereby it is acceptable (Parrino and Kidwell, 2014).

• Internal Rate of Return (IRR) - For achieving financial feasibility, the project must ensure that the project IRR exceeds the discount rate. The underlying rationale is that at discount rate being equal to IRR, the NPV is zero. Hence, if the project discount rate is lower than IRR, then NPV would be positive and hence wealth would be created for shareholders. Project B has an IRR which exceeds the project discount rate and thereby it is acceptable (Damodaran, 2015).

• Payback Period – The company has defined the criterion that projects with payback period in excess of 3 years would be rejected. Project B has a payback period which does not exceed 3 and hence it manages to pass on this criterion implying its acceptance (Petty et. al., 2015).

Conclusion

Based on the above discussion, it would be prudent to conclude that only project B would be accepted since project A would be rejected on failure to comply with payback period requirement.

1. Unlike the above case, where projects were independent, in the case presented the two projects are mutually exclusive. Thus, ranking of the two projects ought to be performed so that the superior one from the choices available can be selected. The comparison of the two projects can be facilitated using the various measures of capital budgeting that have been computed above (Brealey, Myers and Allen, 2014).

• In terms of NPV, Project B would be ranked above Project A since the positive magnitude of NPV is greater for project B in comparison with project A.
• In terms of IRR, Project B would be ranked above Project A since the magnitude of IRR is greater for project B in comparison with project A.
• In terms of Payback Period, Project B would be ranked above Project A since the time required to recover the original outlay is lesser for project B in comparison with project A.

Thus, on account of the above, it would be appropriate to select Project B as the higher ranked project.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2014) Principles of corporate finance, 2nd ed. New York: McGraw-Hill Inc.

Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.

Lasher, W. R., (2017) Practical Financial Management 5th ed. London: South- Western College Publisher.

Northington, S. (2015) Finance, 4^th ed. New York: Ferguson

Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications

Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2015). Financial Management, Principles and Applications, 6^th ed.. NSW: Pearson Education, French Forest Australia.