ECF6110 Business Finance of Financial Accounting

1.The accountant’s estimates in Exhibit 3 use the “most likely” sales projection in Exhibit 1 for each year. Are any of the 11 items listed in Exhibit 3 incorrect for application of the net present value (NPV) method? Have any relevant items been omitted from the list? Consider all information given in the case and explain why.

 

2.Prepare the incremental cash flow table (which incorporates taxes and includes initial investment, operating and terminal cash flows) for the project over the eight years based on the “most likely” sales projection of 1,650,000 pounds per year in Exhibit 1.

 

3.Based on your estimated after-tax net cash flows in Question 2, calculate the payback period, NPV, internal rate of return (IRR) and profitability index (PI) of this project. Assume DP uses a payback rule with cut-off period of five years and the appropriate after-tax discount rate is the company’s cost of capital. Should the project be undertaken based on each of the investment evaluation methods?

 

4.Show a sensitivity analysis of NPV to sales quantity (worst- and best-case scenarios)

 

5.Use the NPVs for the worst-, most-likely- and best-cases of sales quantity estimates (i.e. the figures derived in Questions 3 and 4), and their probabilities of occurrence to find the project’s expected NPV, standard deviation, and coefficient of variation.

 

6.Recall that Walker is quite sceptical of the salesmen’s estimate of the new sales as a result of internal production of the 10-in. and 12-in. pipe. To help him in the evaluation, Walker is interested in the minimum annual increase in new sales necessary to make the project worthwhile. What is this figure assuming equal annual sales? [You may assume that (1) only materials and distribution costs will vary with increased production; (2) no additional equipment is needed; (3) unit selling price is 56 cents per pound; and (4) the relevant after-tax discount rate is 12 percent.]

 

7.Walker used a 12% discount rate to find the present value of annual cash flows caused by any increase in the unit sales of 3-in., 6-in., and 8-in. pipe. He believes this should be 13% and may be even as high as 15%. Does it make sense to use a higher discount rate in Question 6 than in Question 3? How important is this “interest rate concern” to the project if the expected rate of inflation is 3% per year? Justify your answer.

 

8.Based on your answers to Questions 1 – 7 above and other information in the case, what do you recommend? Do you recommend in-house production of the 10-in. and 12-in. pipe?  Defend your advice with the support of your answers.

Introduction

By using the information given for Mr. Walker about his company, this report is prepared to analyze the viability and to give some recommendation about a new production line for two different sizes of pipes in Delaware Pipe.

Delaware Pipe is a company with more than 29 years of background in the pipe market to producing three used sizes of PVC pipe, 3 in, 6 in and 8 in. The company has performed very well in the last year only with these three production lines. However, two other sizes are demanded by the customers, where until the present moment the company have purchased these goods from another company and have sold them.

Company’s owner, Mr. Walker’s has provided relevant information about the company and the marketplace of the firm. In addition, the accountant of the Delaware Pipe has prepared a cost estimation for this production line, which resulted in an unfeasible project for the company.

In the context of project evaluation, using NPV as one of the evaluation’s method, this report will show if the project is consistent with the firm goals. Furthermore, a complementary revision in the accountant’s number will be presented.

Analysis

This section entails detailed analysis of the two options, i.e. producing the pipes internally or buying them. The financial analysis techniques such as Payback Period (PBP), Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index (PI) have been considered in the analysis based on the three scenarios i.e. Worst Scenario, Most Likely, and Best.

Question One

Exhibit 1: Probability Scenarios table

• Exhibit 2: Depreciation Rates for MACRS Property

• Annual Cost of internal production 10-in and 12-in (Accountant estimation)

Net present value (NPV) is a financial tool used to determine whether or not a given project proposal is feasible for investment. A project is feasible if it yields a positive NPV. It is calculated by deducting the initial cash outlay from the discounted cash inflow. Therefore when calculating the Net Present Value the flowing items should be included;

1. The projected cash flow (s).
2. The Initial cash outlay: This is the original cost to be incurred if the proposed project is chosen;
3. And, the discount rate based on the company’s costof capital.

Exhibit 3 items comprise of the costs to be incurred in implementing the new production line. Therefore, the total net cash flows (after tax) should be calculated. Conversely, the loss interest of $120,000 incurred in purchasing the equipment is accounted as the discounting rate and hence should not be included in the NPV’s cash flows (Sekar, Gowri, & Ramya, 2014). Depreciation is included in the calculation of the cash flows because it affects the company’s tax bill. That is, depreciation is deducted from the revenue to obtain the taxable income and then added back to the cash flow after tax. Additionally, the list excludes both the initial cash outlay and discounting rate. Residual value is also included in the discounted cash flow after tax (Gitman, Juchau, & Flanagan, 2011).

Item 3 (Direct labour) and Item 4 (Indirect labour) should be excluded from the computation of the cash flow. Currently, the company is overstaffed and two employees will be retired at the end of three years so as to employ two new ones. The direct labour cost of the employees taken care of and should not be double-deducted. The same case should be considered in treating indirect labour. The plant manager will not be paid an extra amount to supervise the new plant (Deegan, 1960 2013). Since Items (3) and (4) do not apply, the item (5) should be zero. It is not clear whether or not the item (8) represents the current utility cost incurred by the company. Likewise, item (8) on space cost should be excluded because Delaware already has enough space to erect the plant (emeraldinsight, 2017).

Question Two: the incremental cash flow table

The incremental cash flow refers to the additional net cash flow that Delaware will generate by investment in the new product line. It is obtained by deducting the initial cash outlay from the expected new revenue from the new investment (Sekar, Gowri, & Ramya, 2014).

On the other hand, initial cash outlay is obtained from the difference between all the cash outflows and inflows at the beginning of the period (i.e. time zero). Walker disclosed that the total initial cost of equipment is $ 1,000,000 while its useful life is 8 years. Likewise, the inventories will increase by 10% of the annual sales (Peirson, Brown, Easton, Howard, & Pinder, 2015).

Therefore the projected sales and expenses are as follows per annum

 

 

Question Three: Decision Techniques

Note: Rate of Return= 10%.

• Net Present Value (NPV)

Payback Period

Payback=5 years +  = 5.35 years

• Internal Rate of Return (IRR)

IRR refers to the discounting rate when NPV is Zero (0). For the purpose of this study, the trial and error method will be used to calculate IRR.

IRR= LDR + ()*(HDR-LDR)

Note:

LDR= Lower Discounting Rate

HDR= Higher Discounting Rate

NPV of IRR= 0

The NPV at 10 %( LDR) is 456,900.50. Let us try to calculate NPV at 20% (HDR).

NPV at 20% is;

Therefore IRR is;

IRR= 10% + ()*(20%-10%)

=10%+ ()*(10%)

= 10% + (0.51*10%)

=IRR= 10% +5.10%

=IRR= 15.10%

• Profitability Index (PI)

Decision Criteria

According to the NPV, a single propjet should be accepted or rejected is the NPV is greater than zero or less than zero respectively. In this case, the NPV is $ 456,900.50 hence the new plant should be accepted.

According to Payback Period, a single project should be accepted if the period obtained is below or equal to the one set by the management. The company’s payback period is 5 years. However, it would take approximately 5 years and 4 months for the company to recover the initial cash outlay. Under strict adherence to the desired payback period, the project should be rejected. However, four months is a shorter period and the project should be accepted (Deegan, 1960 2013).

According to the IRR technique, the projected should be accepted if the IRR is greater than the cost of capital. In this case, the IRR is 15.1% while the Cost of Capital is 10%. Therefore the project should be accepted.

According to the PI technique, a project should be accepted if the PI is greater than 1. From the calculation, the PI is 1.227 hence the proposed project should be accepted.

Therefore, investing in the new production line for 10 and 12-inch pipes should be accepted because all the methods show positive results (Sekar, Gowri, & Ramya, 2014).

Question 4: Sensitivity analysis of NPV to sales quantity 

Considering the worst- and best-case scenarios

 

The NPV is calculated as;

The NPV at the worst scenario is approximately negative 72,000.

1. b) Best Scenario

 

The NPV at the best scenario is approximately 1,514,460.50.

The NPV at the worst scenario is negative while the NPV at the best scenario shows promising returns. There are the best parameters to evaluate the variation of the returns either way. Therefore, Delaware should consider the most likely scenario because it produces the most realistic results.

Question 5: The project’s expected NPV, standard deviation, and coefficient of variation

1. The Expected Return: Is calculated by multiplying the Expected NPV with Probability.

Therefore, the expected return is 0.17 or 17%.

1. Standard deviation

The standard deviation is 0.105 or 10.5%.

1. the coefficientof variation

Coefficient of Variation (CV) = CV= Std Deviation / Expected Return

= 0.105/ 0.17

= 0.62

The expected revenue, standard deviation and the coefficient of Variation are techniques used represent security or portfolio of the investment. Standard deviation is meant to measure the degree of risks associated with the project returns. A good investment should offer minimum risk for a certain return level or maximum returns for a certain risk level.

The new product line has a standard deviation of 10.5% which represent risks. Likewise, the probability of dispersion is 0.62. The probability of dispersion associated with the three scenarios is insignificantly spread hence there is less risk or variability associated with the return (Gitman, Juchau, & Flanagan, 2011).

Question 6: The minimum annual increase 

The minimum annual increase refers to the project’s break-even point i.e. a number of sales that is required to cover the cost.

 

The cash flow created at a minimum sales volume also shows good results. For instance, the NPV is $ 26,845, the internal rate of return is 29.55% which is higher compared to the 12% cost of capital. Moreover, the profitability index is 1.872 while it would only take the company 3.385 years to recover the initial cash outlay.

Question 7: Does higher discounting rate make sense

Using the company’s current cost of capital in evaluating the new product line of 10-in and 12-in pipes, simply states that the company does not expect the risks associated with its operations to increase. However, considering the volatility in the business environment, factors such as an increase in inflation and interest rates to increase.  The current cost of capital should only be applied when the company is sure that the operating expenses would not increase.

However, with the anticipated increase of inflation by 3% as well as other risks, the company is in order to increase its discounting rate to 12%. It would still be justifiable if the rate is further increased to 15% (Sekar, Gowri, & Ramya, 2014).

Recommendation based on questions 1-7

Based on the calculations and analysis Delaware should invest in building the 10-in and 12-in pipes internally. From the most likely scenario, the project will have a positive NPV of $ 456,744 while the IRR will be 15.10%. Likewise, the Company has the required space, personnel and resources to build the new plant. Considering these factors the project is feasible and should be invested in (Peirson, Brown, Easton, Howard, & Pinder, 2015).

Conclusion

By using the information given for Mr. Walker about his company, this report has been prepared to analyze the viability of the proposed investing in the building of new pipe production plant. The company have purchased these goods from another company and later sell them.

Company’s owner, Mr. Walker’s has provided relevant information about the company and the marketplace of the firm. In the context of project evaluation, techniques such as NPV, IRR, Payback Period, and PI have been used to evaluate the project. The results have shown positive results hence the company should invest in it. Likewise, the report has shown that the project is consistent with the firm goals. Furthermore, Delaware has the required resources, space, and personnel to successfully implement the proposed project.

Recommendations

The Company should go on and implement the development of the 10-in and 12-in pipes project. The recommendation is based on the positive results obtained from the analysis. NPV, IRR, and PI show positive results. Although the Payback period obtained is higher than 5 years, it should be accepted because the variation period is short: Just for months only. Therefore, we agree that the company should invest in the project.

In this section, clearly, state what course of action you recommend and justify your decisions. Include as many recommendations as you need to.

References

Deegan, C. (1960 2013). Financial accounting theory (4th Edition ed.). North Ryde, N.S.W: McGraw-Hill Education.

emeraldinsight. (2017). Property Investment and Finance. Journal of Property Investment & Finance, 35(5).

Gitman, L., Juchau, R. H., & Flanagan, J. (2011). Principles of managerial finance. Frenchs Forest: Pearson Australia.

Peirson, G., Brown, R., Easton, S., Howard, P., & Pinder, S. (2015). Business finance. Sydney: McGraw Hill.

Sekar, M., Gowri, M., & Ramya, G. (2014). A Study on Capital Structure and Leverage of Tata Motors Limited: Its Role and Future Prospects. Procedia Economics and Finance, 11, 445-458.