Fin80005 Financial Management: Capital Budget Assessment Answers

Answer:

Part 1: Introduction 

The current part of the assignment pertains to computations regarding capital budget and for investment appraisal of Riverlea. In this part, the investment upon machinery as a part of the company's business expansion has been examined using capital budget techniques. Daunfeldt and Hartwig (2014) mentioned that capital budgeting techniques examined the expected earnings and revenues generated from a particular investment proposition using a host of parameters. These parameters range from initial capital investment, expected depreciation to cash flows generated and expected present value of the returns from the investments. In the current analysis, a detail financial analysis has been undertaken using discounting factors and expected cash flows for generation of net present value under three situations. Moreover, Capital Asset Pricing Model has been utilized in the current study through computations of beta, risk-free rates and thereby the degree of volatility showcased by River-lea's stock.  Rossi (2014) mentioned that CAPM model takes into account systematic risk pertaining to stocks and thereby assists investors in undertaking buying or sell off decisions based upon their individual risk propensities.        

Findings

There have been three situations provided for the analysis of investment decisions in the current study. This includes the expected revenues generated from the data provided in the assignment and changes in revenues from year 6 onwards.  

At the beginning of the study, the effort has been made to calculate the initial cost and corresponding depreciation. Installation and shipping cost has been added to the purchase cost to arrive at the total initial cost of the project. In this context, it may be noted adjustment for investment in working capital has been performed with the cash flow. Only, the initial investment of $50,000 has been considered in the initial cost calculation.  Total cost, thus, comes to $17, 50,000. Depreciation has been calculated as per reducing balance method.

On the other hand, revenue has been adjusted for the variable costs to arrive at the contribution figure year wise. Loss of operating revenue and operating costs may be construed to be the fixed cost for the given purpose. Depreciation has been adjusted against the profit figure and 30% tax rate has been applied to the profit figure. Investment in working capital has also been adjusted for the cash flow after tax (CFAT) figure.

In the subsequent part of the study, cost of equity has been calculated. Since the given firm is an all-equity firm, cost of equity would mean overall cost of capital for the business. In other words, cost of equity may be considered to be the discounting rate for the purpose of evaluating the aforesaid capital investment project. In this context, it may be noted that the beta has been calculated from the data related to movement in the price of both the stock and the market index. In addition, price data has been provided for G-Bond based on which risk-free rate of return has been averaged to apply CAPM (capital asset pricing model). Once all the data has been collected, CAPM may be applied to find out the cost of equity for the firm. The table below in appendices shows that the discounting factor may be estimated to be 2.54% approximately.

Based on the calculated CFAT and also the discounting rate, the present value of all cash flow has been calculated in the table attached in the appendices below. However, the table herein shows the consolidated figure for 10 years, which depicts that the project is profitable with positive NPV. The project has positive NPV in all probabilistic circumstances. In a normal scenario, the project provides a positive NPV of $2,629,361, whereas, considering all the probabilities, still the project renders NPV to the extent of more than $2.1 million. 

 
Table 1: NPV under the different situations

(Source: Created by author)

Conclusions and Recommendations

Based on the discussion and analysis performed in the preceding sections of the report, it may be construed that the firm should accept the project as the same is rewarding and profitable. However, it may be noted that the management of Riverlea should focus on other non-financial factors such as HR policies, operational efficiencies, legal framework and other market-related externalities which may affect the profitability of the aforementioned capital intensive project. Besides, the management should always consider having a vigilance and check on the activities in the market and economy front so as to validate or revise the assumptions behind the financial modeling.

Part 2

Stock price movement may be construed to be one of the most critical factors for the management to assess, evaluate and decide on the relevant strategies (Grob, 2013). This section of the assignment deals with the analysis of repercussions of the announcements that have been made with regards to the business expansion prospects of Riverlea. The observations pertaining to the stock prices before, after and on the day of the announcement has been examined in the report as well as the degree of riskiness and volatility observed in case of the company’s stocks.   

Findings

As previously discussed, the beta of the firm has been calculated to be -0.56. In this context, it may be interesting to note that the value of beta has a direct effect on the stock price movement. Beta may be defined to be a riskiness or volatility of a stock in relation to the market. In other words, the beta denotes the sensitivity of a stock with reference to the market index. A beta with 1 establishes the fact that the stock price changes in the same direction with that of the market. Therefore, a negative beta suggests that the stock price moves in the opposite direction as compared to the market index. If the market falls, the stock price will increase and vice versa (Abor, 2017).

There have been theories on the semi-strong form of the market which denotes that the stock price encompasses most of the publicly available information but not all and hence, there remains a probability for the investors to have insider's insight and leverage the same accordingly. The semi-strong market is a variation of Efficient Market Hypothesis (EMH) which defines an ideal market that captures all the information and market data about the stock into the market price of the stock.

The stock price movements as can be showcased from the diagram below.

Figure 1: Stock Price Movement

(Source: Created by the author)  

In the instant case, it has been observed that the announcement about undertaking the capital-intensive project has a positive impact on the stock price. Few days before the announcement has witnessed a comparatively lower price level with an average of $1.39; whereas, the day of the announcement has experienced more than 100% increase from $2.16 to $4.35 and the same price level has continued for next few days as well. The diagram that has been showcased above represents that the price movements of the company's stocks have responded positively in terms of the announcements. Thereby, this is showcasing a positive reaction and optimism by the investors and stock market participants regarding the prospects of the company.  The above diagram showcases that the stock prices were showcasing an upsurge before the day of the announcement and it can occur owing to market speculation regarding the possible business expansion by the company.     

The above table showcases quantification of the degree of changes that the stock of the company has been subjected to prior and posts the announcement. The above table showcases a jump in the share price of 80% prior to the day of the announcement as the speculations of the announcement has created a demand for the company’s shares. This can be attributed from the fact that the announcement shall result in the betterment of revenue generation for the company thus resulting in prospective financial benefits for the longer run.        

Conclusions and Recommendations

From the detailed discussion and analysis performed herein, it may be concluded that the stock price changes for various reasons. It is not necessary the financial performance of the firm that influences the movement in the price level of stock of the firm. Investors keep a constant observation on the merger or acquisition-related announcements, announcements related to management, dividend announcements etc. However, the management should consider the financial performance of the company so as to achieve the sustainability in the long run with a strong fundamental growth setting aside the short or mid-term volatility in the market.

References

Abor, J.Y., (2017). Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Springer International Publishing.

Daunfeldt, S.O. and Hartwig, F., (2014). What determines the use of capital budgeting methods? Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4), pp.101-112.

Grob, H.L., (2013). Capital budgeting with financial plans: an introduction. Springer-Verlag.

Rossi, M., (2014). Capital budgeting in Europe: confronting theory with practice. International Journal of Managerial and Financial Accounting, 6(4), pp.341-356.