“Capital Budgeting” and mini- case



“Capital Budgeting” and mini- case

Janet Crawford

Hai Ho Nguyen

Sarah Wilson

University of Phoenix

FIN/540: Managerial Accounting and Finance Foundations

Group #: SBO4MBA06

Instructor: John Sardoni, CPA

December 7, 2004

“Capital Budgeting” and mini- case

INTRODUCTION

This simulation reflects that Silicon Arts Inc. (SAI) is a four-year-old company that manufactures digital imaging integrated circuits (ICs) that are used in digital cameras, DVD players, computers, and medical and scientific instrumentation. It has presence in North America (70% sales), Europe (20% sales), and South East Asia (10% sales). Silicon Arts Inc.’s annual sales turnover is $180 million. As the Financial Analysts at SAI, the team will compute and analyze items (a) through (h) using a Microsoft Excel spreadsheet. Based on items (a) through (h), the company will recommend a company for acquiring. The team of financial analysts will define, analyze, and interpret the answers to items (c) through (h). They will present the rationale behind each item and why it supports the team’s decision stated in item (i). The team will also attempt to describe the relationship between NPV AND IRR. In this memo, the team will explain how they would analyze projects differently if they had unequal projected years. They will also pick two key variables whose values are less than certain. They will consider different values for these two variables. They will tell how different these values would need to be to affect a decision they would make when using them. They will also address the following issue: Given these different values, what other variables could mitigate a decision that might otherwise prove troublesome? A conclusion will also be provided.

COMPUTE AND ANALYZE ITEMS (A) THROUGH (H)

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BASED ON ITEMS (A) THROUGH (H) THE FINANCIAL

ANALYSISTS WILL RECOMMEND A COMPANY FOR ACQUIRING?

The team of Financial Analysts would select company “A” based on the information above. The reason is that company “A” has more income and a higher increase in revenue. It also has less money going out for depreciation, taxes, and discount rates, so the profit bottom line appears to be higher. However, in a real situation where choices would be made between companies, a historical cash flows statement would be more useful in projecting future cash flows. It would reflect not only the net profit, depreciation, taxes, and discount rate of the business, but salaries, benefits, interests, non-recurring expenses, non-cash expenses, equipment, and etc. In addition, after the future cash flows have been projected, they have to be discounted back to their present value. This is done by selecting a reasonable rate of return or capitalization rate for the investment. And the problem with making a selection between companies is that the rate of return varies substantially from one business to the next and is largely a function of risk. The lower the risk associated with an investment in a business, the lower the rate of return that is required.

DEFINE, ANALYZE, AND INTERPRET THE

ANSWERS TO ITEMS (C) THROUGH (H)

The above cash flow projection is a forecast of the difference between cash coming “in to businesses (a) and (b). It also shows cash going “out” of the businesses. This projection will enable the company to budget the cash needs of the business over a 5- year period of time. The ability to predict and plan cash outlays means that the company will not be forced to resort to unexpected borrowing (which would be more costly) to meet their cash needs.

The cash flow statement above, however, shows that company (a) has a higher net income $236,983.88 over company (b’s) $146,887.69. Company (b) has a higher increase in revenue of $129,990 over company (a”s) $110,510.00. Company (b) also has a higher depreciation rate of $50,000 over company (a’s) $25,000. Company (b’s) taxes are higher and so is its discount rate. The total cash flow for company (a) is $158,815.38 and $10,081.38 for company (b.

PRESENT THE RATIONALE BEHIND EACH ITEM AND WHY IT SUPPORTS THE TEAM’S DECISION STATED IN ITEM (I)

Because the net result for company “A” is positive and has greater value, the team decided to select that company. It also appears to have similar, but fewer risks compared to company “B”. In addition it is the company with the highest NPV, so it should be accepted. At the investor’s alternative rate of return, NPV is the contribution to the company’s net wealth from undertaking the project. Another reason is that the profitability index is greater than 1.0, which is acceptable; in fact, the number is higher than that of Dig-image. Therefore, it is more financially attractive. Yet another reason is that Dig-image’s IRR is 20.20% where as W-Comm’s is 26.90% which is the bottom line of this investment.

DESCRIBE THE RELATIONSHIP BETWEEN NPV AND IRR

The relationship is derived for net present value (NPV) per dollar invested that is composed entirely of interest rates. The IRR is the discount rate that results in a NPV of zero for a series of future cash flows. It is a discounted cash flow approach to valuation and investing just as NPV. Both IRR and NPV are widely used to decide which investments to undertake and which investments not to make (Value Based Management, 2004).

EXPLAIN HOW THEY WOULD ANALYZE PROJECTS

DIFFERENT IF THEY HAD UNEQUAL PROJECTED YEARS

If annual cash flows are equal, the payback period is found by dividing the initial investment by the annual savings.

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But if the payback period differs from year to year, the payback period is determined when the accrued cash savings equal the initial investment cost (i.e. when the cumulative cash flow balance equals zero).

TWO KEY VARIABLES WHOSE VALUES

ARE LESS THAN CERTAIN

Cash inflow and cash outflow, are key variables with values that are less than certain in determining the internal rate of return. The internal rate of return is the amount of profit you get by investing in a certain project. An IRR of 10% means that that you expect to make 10% profit per year on the money invested in the project. This variable assumes that all cash flows from the project are invested back into the project. However, sometimes, that is not possible. For example: if you invest that 10% in a company, expectations are that you will make 10% on return, however, if that company has a greater outflow of cash or the inflow does not meet time deadlines, there will be no 10% to re-invest back into the project. IRR, however, will take you to the bottom line of an investment. It tells you the rate of return on a complicated series of cash flows. This can be measured against what can be earned in a risk-free investment to determine the desirability of this investment. This variable, however, is believed to be less than certain because it does not work when there are multiple changes in the cash flow. In addition, IRR is the discount rate that sets all cash inflows and outflows to 0. More weight is given to the earlier cash flow than to the later cash flow because of the time value of money (IRR Calculator, 2004).

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As reflected in the example above, the standard IRR, represented in the darker color, calculation is higher than the Modified IRR with reinvestments at cost of capital, because the project based on IRR dropped to the interim investment rate rather than the calculated rate. The IRR will be greater when interim cash flows occur sooner. This concept may seem counterintuitive, since companies would prefer to have cash sooner rather than later. The reason for the problem is that the gap between the reinvestment rate and the assumed IRR exists for a longer period of time, so the impact of distortion accumulates (McKinsey on Finance, 2004).

The volume of sales, and prices that impact cash inflow, and the costs of marketing and etc., that impacts cash outflow are also variables that makes the profitability Index less than certain. The profitability index is determined by dividing the present value of each proposal by its initial investment. An index value greater than 1.0 is acceptable and the higher the number, the more financially attractive the proposal is. The profitability index is a good tool to use to find out which project will give the company the highest value per dollar of investment. In the scenario, it compares the Digital Imaging segment to the Wireless Communication market. However, PI tends to favor smaller projects like IRR. In an environment where money is not a problem, this key variable could mislead the company because it attempts to identify the relationship between the cost and benefits of a proposed project through the use of a ratio calculated as: =

PV of Future Cash Flows

Initial Investment

Profitability Index, is intended to answers the question “can the company make money”? As with the IRR, there are many uncertainties that could result in inaccurate reporting by this method. Changes in working capital, depreciation, profit after taxes, and etc., have to be taken into consideration. However, in the scenario, SAI’s main risks are that their market share in the Digital Imaging (IC) segment faces a risk of being eroded by comparable products. In such a scenario, the investors might be looking at returns of 19% instead of 17%. The Wireless Communication market is growing but is also risky. The investors would be looking at about 20% instead of the 18% returns considered. However, IRR is projected to be 20.20% for Dig-Image, and 26.90% for W-Comm, but there are uncertainties, that might affect those projections.

CONSIDER DIFFERENT VALUES FOR THESE TWO VARIABLES

The net present value (NPV) is a different value of a capital budgeting project that considers the expected impact of the project on the value of the firm. It is a way of comparing the value of money now with the value of money in the future. A dollar today is worth more than a dollar in the future, because inflation erodes the buying power of the future money. Money available today as in the case of SAI, can be invested and grow. However, in the scenario, the project with the greater positive NPV is expected to increase in higher value. Dig-image’s NPV (in $’000s) is $2,000 and W-Comm’s NPV is $8,430. The NPV is calculated as the present value of the project's cash inflows minus the present value of the project's cash outflows. This relationship is expressed by the following formula:

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CFt = the cash flow at time t and, r = the cost of capital (Net Present Value, 2004).

HOW DIFFERENT WOULD THESE VALUES NEED TO BE TO AFFECT A

DECISION YOU WOULD MAKE WHEN USING THEM?

The NPV is the difference between the present value of the future cash inflows, and the present value of the future cash outflows, and the PI is the ratio of these two, the decision criteria are related, however, the team’s decision would be affected as follows:

Accept if NPV > 0 or PI > 1.0, and

Reject if NPV < 0 or PI < 1.0 (Capital Budgeting Techniques, 2004).

The inflow or cost of capital would have to reflect the higher future value of money, which typically has two components: an adjustment for inflation, and a risk-adjusted return on the use of the money. The discount rate would have to be at the appropriate prime rate of the highest risk-adjusted rate of return that the company can obtain by investing its money, or it would have to be at the lowest rate at which they can borrow money, whichever is higher. The reason is that the company wants to maximize its profits for re-investment. For example, Dig-image cash flow statement reflects that their profit after tax is $6,072 at year 5, and their expenses are $42, 428, with a net cash flow of $21,898. W-Comm has after tax profits of $6,699 at year 5, expenses of $52,869, and a net cash flow of $19,866. At this time Dig-image has working capital of 0, and W-Comm has working Capital of $8,351. As a result W-Comm would be selected because Dig-image has nothing to re-invest.

GIVEN THESE DIFFERENT VALUES, WHAT OTHER VARIABLES COULD MITIGATE A DECISION THAT MIGHT OTHERWISE PROVE TROUBLESOM?

The discount rate could also present problems, in other words, if the discount rate used is lower than the APR of the interest rate for the loan, the NPV will be higher than the original loan balance. Likewise, if the discount rate is higher, the NPV will be lower. The higher the discount rate, the less expensive (more discounted) the future payments will be (Smartstudent Guide, 2004). For example, when the discount rate is somewhat higher than the APR of the interest rate, the graduated repayment plan has a lower NPV than the standard or extended repayment plan because it shifts the larger payments toward later in the term when the constant dollar value of the payments is lower.

The payback variable, could also present a problem because it is supposed to tell the company how long it will take to earn back the money spent on the project at a non-discounted rate. The formula is:

|Cost of Project |= Payback Period |

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|Annual Cash Inflow | |

Thus, if a project cost $50,000 and was expected to return $12,000 annually, the payback period would be $50,000 ÷ $12,000, or 4.16 years. If the return from the project is expected to vary from year to year, you can simply add up the expected returns for each succeeding year. Under the payback method of analysis, projects or purchases with shorter payback periods rank higher than those with longer paybacks. The theory is that projects with shorter paybacks are more liquid, and thus less risky — they allow the company to recoup their investment sooner, so that they can reinvest the money elsewhere. However, with any project there are a lot of variables that are unclear, for example, when looking into the future. With a shorter payback period, there's less of a chance that market conditions, interest rates, the economy, or other factors affecting the project will drastically change. Generally, a payback period of three years or less is preferred. Some advisors say that if the payback period is less than a year, the project should be considered essential. There are, however, a couple of drawbacks to using the payback period method. For one thing, it ignores any benefits that occur after the payback period, so a project that returns $1 million after a six-year payback period is ranked lower than a project that returns zero after a five-year payback period. But probably the major criticism is that a straight payback method ignores the time value of money. To get around this problem, you should also consider the net present value of the project, as well as its internal rate of return. In addition the payback period method cannot identify the investments that maximize the company’s wealth, but it can be used as a rough (and simple) screening device. There is also a strong argument for excluding working capital from payback calculations because the objective is to appraise the project opposed to calculating how much net cash flow is generated each year. Management wants to know how quickly the project will recover at least the initial capital outlay. And working capital is (or should be) fully recovered at the end of the project (Solution to Budgeting Techniques, 2004).

The discounted payback period measures how quickly the benefits from the investment “pay back” after adjusting cash flows for the time value of money using discounted cash flows. This method can also present problems because it cannot help with ranking or selecting among profitable projects. The Discounted Pay back method can be used in two ways. The first is that the company can decide to only accept investment projects that "pay back" discounted cash flows within a predetermined time, or secondly, the company can select between competing investment projects by selecting those with the shortest pay back periods using the discounted cash flow method. This method measures how long it will take to recover the initial investment, with emphasis on the discounted payback period in terms of discounted cash flows. This method, however, can screen out investments that do not have any present value. If the investment never “pays back” in terms of discounted cash flows, this means that they have either a zero or negative present value (Solution to Budgeting Techniques, 2004).

The modified internal rate of return (MIRR) can also be problematic. This calculation uses the initial investment amount, a series of projected after-tax cash flows which are ran forward at a rate that the company supplies and the after-tax sales proceeds in a given year to calculate a future wealth dollar amount for year one through 5. An average year-to-year return is then calculated using the initial investment amount and the future wealth dollar amount for each of the 5 years. The following is a copy of Dig-image’s cash flow statement that is intended to reflect information needed to calculate the MIRR.

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An MIRR example is that if the company is looking at year 5, they would use the initial investment amount, the series of after-tax cash flows for years 1 through 5, the after-tax return on the cash flows based on the interest rate supplied and the after-tax sales proceeds in year 5 to calculate a future wealth dollar amount for year 5. The company can then take the initial investment amount and the future wealth dollar amount that was calculated for year 5 and determine an average yearly return that would be required to accumulate the dollar amount over the five year period. The MIRR calculation provides a better average return estimate since the interest rate to run the cash flows forward were supplied. The problem is that cash flows are not ran forward at internal rates because that could greatly exaggerate the return on investment (Advantage Software LLC, 2004).

CONCLUSION

In conclusion, Theoretically, NPV is considered to be the most reliable criterion for project evaluation and is the best measure to base the team’s decision. Generally speaking, the lower the NPV, the better the loan, but since the relative order of the NPV values for different loans depends on the discount rate (i.e., whether it is higher or lower than the APR of the interest rate under standard amortization); care should be exercised in the choice of a discount rate (Smartstudent Guide, 2004).

Reference:

Advantage Software LLC, 2004). Retrieved November 20, 2004, from



Capital Budgeting Techniques (2004). Retrieved November 20, 2004, from



IRR Calculator (2004), Retrieved November 20, 2004, from

financial%20calculators/irr.htm

McKinsey on Finance (2004). Retrieved November 20, 2004, from



no12/IRR%20caution.pdf

Osborne, M. (May, 2004) Retrieved November 20, 2004, from



Net Present Value (2004), Retrieved November 20, 2004, from

.

Smartstudent Guide (2004). Retrieved November 20, 2004, from



Solution to Budgeting Techniques (2004). Retrieved November 20, 2004, from

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Value Based Management, 2004, Retrieved November 20, 2004, from



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