PACC6003 Business Finance For Annual Loan Repayment

Questions:

(1) Construct a table showing your calculations of net cash flow after tax (NCFAT). Use the method shown in lectures and notes.

(2) Calculate the NPV. Is the project acceptable? Why or why not?

(3) Conduct a sensitivity analysis showing how sensitive the project is to operating expenses and to the cost of capital. Explain.

(4) Describe and explain the types of ‘managerial options’ that may be relevant to Multimakks Limited in the context of this project.

Answers:

The following table shows the amount of the annual loan repayment and the repayment schedule.

Year	PV Factor @ 8.6%
1	0.9208103131
2	0.8478916327
3	0.7807473597
4	0.7189202207
5	0.6619891535
PVIAF	3.9303586798

Let x be the instalment amount, present values of which altogether would amount to total loan amount. Then we get the instalment amount to be,

x PVIAF(8.6%, 5) = 24,00,000

Solving the above equation provides us with each instalment amount to be $ 610,631.29.

The loan repayment schedule for next five years is presented below:

Year	Opening Principle	Interest @ 8.6%	Instalment	Principle Repaid	Outstanding Principle
1	24,00,000.00	2,06,400.00	6,10,631.29	4,04,231.29	19,95,768.71
2	19,95,768.71	1,71,636.11	6,10,631.29	4,38,995.18	15,56,773.52
3	15,56,773.52	1,33,882.52	6,10,631.29	4,76,748.77	10,80,024.75
4	10,80,024.75	92,882.13	6,10,631.29	5,17,749.16	5,62,275.59
5	5,62,275.59	48,355.70	6,10,631.29	5,62,275.59	-

NPV of the project (to the nearest dollar)

The net present value helps calculate the value created by the project by subtracting the present values of outflows from that of inflows. So, if the difference is positive the project is viable and should be accepted, and vice versa. The following table shows us the calculation of net present value of the project:

Particulars	0	1	2	3	4	5
Initial Investment	-24,00,000	-	-	-	-	-
Cash Inflows	-	20,80,000	12,00,000	19,30,000	11,05,000	12,45,000
Cash Outflows	-	-6,10,631	-6,10,631	-6,10,631	-6,10,631	-6,10,631
Net Cash Flows	-24,00,000	14,69,369	5,89,369	13,19,369	4,94,369	6,34,369
PV Factor @ 13.8%	1	0.87873462	0.77217454	0.67853650	0.59625351	0.52394861
PV of Cash Flow	-24,00,000	12,91,185	4,55,096	8,95,240	2,94,769	3,32,377
NPV	8,68,666

IRR of the project (as a percentage to two decimal places)

In order to calculate the internal rate of return of the project, we need to equate the present values of inflows and outflows, Therefore IRR,

PV of Inflow= PV of Outflows

Particulars	0	1	2	3	4	5
Net Cash Flows	-24,00,000	14,69,369	5,89,369	13,19,369	4,94,369	6,34,369
PV factor @ 30%	1	0.769230769	0.591715976	0.455166136	0.350127797	0.269329074
PV @ 30%	-24,00,000	11,30,284	3,48,739	6,00,532	1,73,092	1,70,854
PV [email protected] 31%	1	0.763358779	0.582716625	0.444821851	0.339558665	0.259205088
PV @ 31%	-24,00,000	11,21,656	3,43,435	5,86,884	1,67,867	1,64,432

With the help of Interpolation, we get the IRR to be approximately 30.60%.

PB, the payback in years (to one decimal place)

Payback Period

a+(b/c)

Where,

a= the last period having a negative cumulative cash flow;
b= is the absolute value of cumulative cash flow at the end of the period a as mentioned above;
c= is the total cash flow for the period after a

Year	Cash Flow	Cumulative Cash Flow
0	-24,00,000	-24,00,000
1	14,69,369	-9,30,631
2	5,89,369	-3,41,263
3	13,19,369	9,78,106
4	4,94,369	14,72,475
5	6,34,369	21,06,844

Payback Period

= 2 + ( 341263 / 1319369 )

= 2.3 years

ARR, the accounting rate of return (to two decimal places)

Calculation of Accounting Profit
	0	1	2	3	4	5
Initial Investment	-24,00,000
Cash Inflows	-	20,80,000	12,00,000	19,30,000	11,05,000	9,20,000
Interest Outflows	-	-2,06,400	-1,71,636	-1,33,883	-92,882	-48,356
Depreciation	-	-19,98,720	-11,66,453	-6,80,742	-3,97,281	-2,31,853
Salvage Value			-			3,25,000
Accounting Profit	-24,00,000	-1,25,120	-1,38,089	11,15,376	6,14,837	9,64,791

The formula for calculation of depreciation be diminishing balance has been mentioned below:

Depreciation Rate = 1- (Salvage Value/Acquisition value) ^ (1/n)

Putting the relevant data in above formula we get the depreciation rate to be 41.64% per annum. The following table shows us the calculation of depreciation:

Opening Value	Depreciation @ 41.64%	Closing Value
48,00,000.00	19,98,720.00	28,01,280.00
28,01,280.00	11,66,452.99	16,34,827.01
16,34,827.01	6,80,741.97	9,54,085.04
9,54,085.04	3,97,281.01	5,56,804.03
5,56,804.03	2,31,853.20	3,24,950.83

Average Accounting Income = Total Income/No. of years of the project = (24,31,794/5) = $4,86,359

Accounting Rate of Return = (486359/2400000)*100 = 20.26% per annum

PI (present value index or profitability index) (to two decimal places)

Profitability Index	=	Present Value of Future Cash Flows
Profitability Index	=	Initial Investment Required
	=	32,68,666
	=	24,00,000
	=	1.36 times

Taking the above calculations into consideration, we can say that the project is acceptable. The project overall seems to create value for the company and hence based o that we can say that the project should be accepted. Let us now analyse individual heads for consideration of this project (Atrill and McLaney, 2009):

Net Present Value: the net present value is the most common way to determine the viability of a project. The net present value calculated the value that can be created form the project. it is calculated by subtracting the present values of the outflows from the present values of cash inflows (Banks and Giliberti, 2008). The positive value indicates that project would earn more than what is to be invested in the beginning. Negative value shows that whatever was invested would also be not recovered. Therefore when the NPV is positive the project should be accepted, if negative then not. From the above calculations we see that the net present value of the project amounts to $868666, which is positive and the company should accept the project. (Bhattacharyya, 2011)

Internal rate of return: Internal rate of return is another tool which helps in determining the acceptability of the project. The internal rate of return is calculated by equating the present values of the cash inflows with the present values of cash outflows (Harrison, Horngren and Thomas, 2015). This helps to determine the real return which is to be earned by the project. This process of calculation of internal rate of return involved interpolation. If the internal rate of return from the project results to be greater than the cost of the project, then it indicates positive returns, and hence the project should be accepted, else vice versa. In the given case we see that the required rate of return for the given project is 13.8 %, whereas the internal rate of rate is 30.60%, this indicates that the project will generate positive values for the investors and hence the project should be accepted. (Izhar and Hontoir, n.d.)

Payback Period: the payback period method is one of the tools of capital budgeting which helps the investors analyse the period for which there investment amount will be recovered. The payback period approximately calculate the time period in which the whole amount investment will be recovered (Kimmel, Weygandt and Kieso, n.d.), after which all the cash flows form part of the earnings. Lower the payback period, better it is for the investors. In the given scenario the payback period results to be 2.3 years. The project involves a huge investment in order to start up, taking which into consideration the payback period of 2.3 years seems appropriate and hence the project is viable to be accepted. (Lalli, 2012)

Average Rate of Return: the average rate of return calculates the average percentage of profits which are expected to be earned over the period of the project (Lee and Epstein, 2012). Under this method we calculate the return from the project for each year, these returns are then added together in order to calculate the average return per year. This return is then divided by the investment amount in order to calculate the percentage of return per year. In the given scenario we see that the average rate of return amounts to approximately 20 percent per year for years. Therefore, the based on the average rate of return the project should be accepted as the cost if less than the return earned per year. (Loganathan, n.d.)

Profitability index: profitability index is more popularly known as profit investment ratio. This helps in calculation of ratio between the cash flow earned and the investments earned by the company. This ratio is considered viable when it is high (Loughran, 2011). This means higher the ratio better for the company. In the given case the ratio results to be 1.36 times which is satisfactory. Based on this calculation the project seems viable and should be accepted. (Piper, 2015)

Note: for the calculations made below, we have not taken the expenses incurred on feasibility study into consideration as the nature of expense is sunk and already incurred.

Particulars	0	1	2	3	4	5
Initial Investment
- Capital Costs	-128,00,000	-	-	-	-	-
- Working Capital	-3,70,000	-	-	-	-	-
Operating transactions
Sales	-	161,16,000	170,95,853	181,35,281	192,37,906	-
Cash operating Expenses	-	-109,58,880	-116,25,180	-123,31,991	-130,81,776	-
Sales and Marketing Expense	-	-2,51,000	-2,56,020	-2,61,140	-2,66,363	-
Head Office expenses	-	-2,30,000	-2,30,000	-2,30,000	-2,30,000	-
Depreciation	-	-59,20,000	-31,82,000	-17,10,325	-9,19,300	-
Working capital recovery	-	-	-	-	3,70,000	-
Salvage value	-	-	-	-	9,60,000	-
Profit before tax	-131,70,000	-12,43,880	18,02,653	36,01,824	60,70,467	-
Less: Investment Allowance	-	-	-15,51,653	-10,08,347	-	-
Adjusted profit before tax	-131,70,000	-12,43,880	2,51,000	25,93,477	60,70,467	-
Tax @ 27%	-	-	-	-	7,00,239	16,39,026
Profit After Tax	-131,70,000	-12,43,880	2,51,000	25,93,477	53,70,228	-16,39,026
Add: Depreciation	-	59,20,000	31,82,000	17,10,325	9,19,300	-
Net Cash Flow after Tax	-131,70,000	46,76,120	34,33,000	43,03,802	62,89,528	-16,39,026

The following table shows us the calculation for NPV of the project:

Particulars	0	1	2	3	4	5
Net Cash Flow after Tax	-131,70,000	46,76,120	34,33,000	43,03,802	62,89,528	-16,39,026
PV @ 10.65%	1	0.903750565	0.816765083	0.738151906	0.667105202	0.602896703
Present Values	-131,70,000	42,26,046	28,03,955	31,76,860	41,95,777	-9,88,163

The NPV of the project amounts to $ 244474, the NPV is positive and the project should be accepted.

In order to have the sensitivity analysis the NPV the project will be calculated increasing the operating expenses by 1%, at 68.68% (68%*1.01=68.68%), we get the following:

Particulars	0	1	2	3	4	5
Initial Investment
- Capital Costs	-128,00,000	-	-	-	-	-
- Working Capital	-3,70,000	-	-	-	-	-
Operating transactions
Sales	-	161,16,000	170,95,853	181,35,281	192,37,906	-
Cash operating Expenses (68*1.01=68.68%)	-	-110,68,469	-117,41,432	-124,55,311	-132,12,594	-
Sales and Marketing Expense	-	-2,51,000	-2,56,020	-2,61,140	-2,66,363	-
Head Office expenses	-	-2,30,000	-2,30,000	-2,30,000	-2,30,000	-
Depreciation	-	-59,20,000	-31,82,000	-17,10,325	-9,19,300	-
Working capital recovery	-	-	-	-	3,70,000	-
Salvage value	-	-	-	-	9,60,000	-
Profit before tax	-131,70,000	-13,53,469	16,86,401	34,78,504	59,39,649	-
Less: Investment Allowance	-	-	-15,51,653	-10,08,347	-	-
Adjusted profit before tax	-131,70,000	-13,53,469	1,34,748	24,70,157	59,39,649	-
Tax @ 27%	-	-	-	-	6,66,942	16,03,705
Profit After Tax	-131,70,000	-13,53,469	1,34,748	24,70,157	52,72,707	-16,03,705
Add: Depreciation	-	59,20,000	31,82,000	17,10,325	9,19,300	-
Net Cash Flow after Tax	-131,70,000	45,66,531	33,16,748	41,80,482	61,92,006	-16,03,705
PV @ 10.65%	1	0.903750565	0.816765083	0.738151906	0.667105202	0.602896703
Present Values	-131,70,000	41,27,005	27,09,004	30,85,831	41,30,720	-9,66,869

% Change in NPV	244474-(-84309)*100	134.49%
	244474

NPV at 68% was $ 244474, NPV at 68.68% is -84309, and this indicates that for every one percent increase in operating expenses the NPV of the project will decrease by 134.49%.

Let us now do the same by increasing the cost of capital by 1% at 10.7565% (10.65*1.01=10.7565%)

Particulars	0	1	2	3	4	5
Initial Investment
- Capital Costs	-128,00,000	-	-	-	-	-
- Working Capital	-3,70,000	-	-	-	-	-
Operating transactions
Sales	-	161,16,000	170,95,853	181,35,281	192,37,906	-
Cash operating Expenses	-	-109,58,880	-116,25,180	-123,31,991	-130,81,776	-
Sales and Marketing Expense	-	-2,51,000	-2,56,020	-2,61,140	-2,66,363	-
Head Office expenses	-	-2,30,000	-2,30,000	-2,30,000	-2,30,000	-
Depreciation	-	-59,20,000	-31,82,000	-17,10,325	-9,19,300	-
Working capital recovery	-	-	-	-	3,70,000	-
Salvage value	-	-	-	-	9,60,000	-
Profit before tax	-131,70,000	-12,43,880	18,02,653	36,01,824	60,70,467	-
Less: Investment Allowance	-	-	-15,51,653	-10,08,347	-	-
Adjusted profit before tax	-131,70,000	-12,43,880	2,51,000	25,93,477	60,70,467	-
Tax @ 27%	-	-	-	-	7,00,239	16,39,026
Profit After Tax	-131,70,000	-12,43,880	2,51,000	25,93,477	53,70,228	-16,39,026
Add: Depreciation	-	59,20,000	31,82,000	17,10,325	9,19,300	-
Net Cash Flow after Tax	-131,70,000	46,76,120	34,33,000	43,03,802	62,89,528	-16,39,026
PV @ 10.7565% (10.65*1.01=10.7565)	1	0.902881546	0.815195087	0.736024601	0.66454303	0.600003638
Present Values	-131,70,000	42,21,982	27,98,565	31,67,704	41,79,662	-9,83,422

% Change in NPV	244474-214492*100	12.26%
	244474

NPV at 10.65% was $ 244474, NPV at 10.7565% is 214492, that means for every one percent increase in Cost of Capital the NPV of the project will decrease by 12.26%.

The decision of capital budgeting is s very important decision making process (Shim, Siegel and Shim, 2013). When the investors look forward to take up a project they should not only look in the quantitative aspects but other important aspects should also be taken care of before acceptance of any project. The managerial decision of the company should be appropriate and suitable to the environment and nature of the project. This should be check before finalising the managing team for the said project (Warren., 2015). The management group so selected should not be rigid and should be flexible so that any changes which are required by the project in near future can be met with. The value of the project involves the flexibility option embed in it. It helps the company for future expansion possibilities. Therefore before appointment of the managerial tea for the project all points should be taken care of (Weygandt, Kimmel and Kieso, n.d.).

References

Atrill, P. and McLaney, E. (2009). Management accounting for decision makers. 1st ed. Harlow: Financial Times/Prentice Hall.

Banks, A. and Giliberti, J. (2008). Budgeting. 1st ed. Boston: McGraw-Hill.

Bhattacharyya, D. (2011). Management accounting. 1st ed. Noida, India: Pearson.

Harrison, W., Horngren, C. and Thomas, C. (2015). Financial accounting. 1st ed. Boston: Pearson.

Izhar, R. and Hontoir, J. (n.d.). Accounting, costing and management. 1st ed. Oxford: Oxford University Press.

Kimmel, P., Weygandt, J. and Kieso, D. (n.d.). Financial Accounting. 1st ed.

Lalli, W. (2012). Handbook of budgeting. 1st ed. Hoboken (N.J.): Wiley.

Lee, J. and Epstein, M. (2012). Advances in Management Accounting. 1st ed. Bradford: Emerald Group Publishing Limited.

Loganathan, N. (n.d.). Foundations of budgeting. 1st ed. Sydney: UNSW Press.

Loughran, M. (2011). Financial accounting for dummies. 1st ed. Hoboken, N.J.: John Wiley & Sons.

Piper, M. (2015). Accounting made simple. 1st ed. [United States]: [CreateSpace Pub.].

Shim, A., Siegel, J. and Shim, J. (2013). Budgeting basics and beyond. 1st ed. Hoboken, N.J.: Wiley.

Warren. (2015). Financial Accounting. 1st ed. Cengage Learning.

Weygandt, J., Kimmel, P. and Kieso, D. (n.d.). Financial accounting. 1st ed.

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