Calculating the best changes to make as technology moves on

Calculating the best changes to make as technology moves on

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Due to the change of technology, the company wants to choose one project to invest to keep the leading position in the market. The table below shows the key comparison of Project 1 and Project 2.

Project 1

Project 2

Original

Up-Front Investment

2,500,000

2,500,000

0

Growth Rate

10%

2.5%

1.94%

COGS

94.78%

93.83%

94.78%

Table1. Overall Comparison between Project 1 and 2

Based on company's financial statement of 2009 and 2010, we project the cashflows the following 5 years, with Project 1 and B respectively. All the information and ratios we use in our prediction are obtained directly from case study, Yahoo Finance and Bloomberg. The analysis and predictions show that Project 2 is more profitable and promising. The following parts will illustrate all the calculations and interpretation.

Analytical Techniques

All the key techniques we used to predict and analyze are listed as below.

Calculate key ratios: We used the company's historical ratios from the company's most recent year, 2009-2010, of operations to project the results. It is assumed that these ratios keep unchanged over the years, unless told otherwise by the instructions.

Forecast Income Statement, Balance Sheet and Cashflows: For the original cashflows (without projects) and balance sheet, we used the company's historical ratios from year 2009 to 2010, and assumed that those ratios stay the same during the projection period. With Project 1 or Project 2, we adjusted the ratio according Table1.

Income Statement: All expense account balances (except for Taxes) are projected using common size. Forecast taxes using tax rate.

Prepaid, Other Payables, Land, Goodwill, Customer List, Technology, Trademarks and Investment are kept the same balance as the most recent year.

Balance Sheet: Deferred Revenue and Accrued Expenses grow at the sales growth rate. Capitalized Software grows year to year growth rate. Assets and Liabilities are predicted using Turnover and Growth Rate. If the turnover does not exist, we kept it balance same with prior years.

WACC (Weighted Average Cost of Capital): WACC evaluates the return of the firm's investors could expect to earn if they invest in the project with similar risk. The discount rate is calculated based on several factors and sources listed below:

Income Tax Rate: 32.59%, specified in Case Study

Prime Rate: 3.25%, obtained from bankrate.com

Interest Rate: 5.25%, specified in Case Study

Beta: 0.72, obtained from Yahoo Finance on 11/20/2010

Risk Free Rate: 2.890%, obtained from Bloomberg.com on 11/21/2010

Market rate of Return: 11%, specified in Case Study

Market Premium: 8.38%, specified in Case study

WACC=Interest Rate*Debt/(Debt+ Equity)*(1-Tax Rate)+Cost of Equity*Equity/(Debt+Equity)

Cost of Equity=Risk Free Rate+Beta*(Market Return Rate-Risk Free Rate)

The detailed calculations for CAPM, Equity Ratio, Debt Ratio and WACC can be referred to the Spreadsheets.

Key Indicators: After calculating WACC and predicting the cashflows, we are able to calculate other key indicators to evaluate these two projects. Such indicators include: NPV (Net Present Value), IRR (Internal Rate of Return), PI (Profitability Index), EVA (Economic Value Added) for each year, and the Payback period for each project. We use differences between original cash flow and cash flow with project to calculate NPV. Later on Project feasibility analysis is based on those key indicators.

Sensitivity Analysis Besides we need to find the most sensitive factor of this investment. We performed the sensitivity analysis and considered the uncertainty of COGS, Upfront Investment and Sales Growth. To achieve that, we set NPV = 0 and use Goal Seek of Excel tools to see how COGS, Upfront Investment and Sales Growth change.

EMV We analyzed the Expected Monetary Value (EMV) for each project under different Sales Growth Rate, and calculated the expected NPV when there are different growth rates.

Comparison between Project 1 and B We compared the performance indicators of the projects A and B to recommend which one is better from a financial point of view.

Feasibility Analysis for Project 1

The cash flow, NPV and other analysis are listed in the following appendix. We can draw the conclusion that it is non-profitable to conduct Project 1 for the following reasons.

NPV: Negative NPV ---- (1625474.89) thousands, means investment in Project 1 would subtract 1625474.89 value from firm. Project 1 should be rejected.

IRR: Negative IRR ---- (18%), much smaller than WACC, which is 5.82%. That's why Project 1 should be rejected.

Probability Index ---- 0.35, smaller than one, which means that for every dollar that is invested in Project 1, the company could only get $0.35 back. It means Project 1 can only make the company loose money. That's another reason for rejecting Project 1.

EVA: EVA is positive in some years and negative in some years during the project. It means that during the project year, the project might add value to the company, or might decrease value from the company. When the EVA is negative in certain years, it means that the company will have to be prepared for a very tough year since the company might have to collect more money to support the project.

Pay back: The company cannot get pay back during the project time. It means that by the time the project ends, it still can't get back the money that the company has invested in the project. That's why we shouldn't consider Project 1.

Sensitivity analysis: It is shown that for project 1 the most sensitive factor is COGS, which has the smallest tolerance. It means among all the influential factors, this factor (COGS) can cause the greatest change to the project if they change in the same rate. Now there is an equal chance that the project will have a Sales Growth (the least sensitive factor) of 7.5%, 10%, 15%, it's obvious that Project 1 is still very risky since a slight change in the least sensitive factor is highly improbably to save the project. Furthermore, the upfront investment is also very sensitive in calculating NPV. When the Upfront Investment decreases from $2,500,000 thousands to 873380, NPV increases from negative 1626619 to zero.

EMV: Negative EMV--- (1521200). There are equal chances that sales growth will be 7.5%, 15%, 10% for Project 1. Negative EMV means that if we look at it in the big picture and take the possibility of different growth rate into consideration, this project would still be not profitable for the company.

Conclusion: From the analysis above, Project 1 should not be considered given the fact that its NPV and IRR is negative, EVA is not good, payback is impossible, and EMV is negative.

Feasibility Analysis for Project 2

We analyze the NPV, IRR, EMV, Pay Back, EVA, Probability Index and the sensitivity of the project. For each of the parameters, we could get the following results.

NPV: Positive NPV with value of 427569.66 thousand dollars. Compared with when there is no new project, project 2 will add extra 427569.66 thousand dollars to the company. Therefore, we should consider investing on project 2.

IRR: The value of IRR is 15%, while WACC is 8.5%. When IRR is higher than WACC, the company could invest on the project because it's financially viable and acceptable.

Profitability Index: The value of Profitability Index is 1.17. That means, for every one dollars' investment on project 2, the company could get the revenue of 1.17 dollars. So, the company could get 0.17 dollars' profit for the investment of one dollar on project2. We should adopt Project 2.

EVA: The EVA for project 2 during each year is always positive. It shows us that project 2 could generate revenue for the company in each year. It has no tough years. But, the company should finance it until it could finance itself.

Payback: Payback period of the company is 4.11 year. Since the payback period is shorter than its lifetime, it suggests that at the year of payback, the project can get back the money the company invested in it. That's why we could invest on project 2.

Compared with when there is no investment for project, project 2 generates cash for the company during each year. Since the EVA is also positive, the project is profitable to the company each year.

Sensitivity Analysis: Cost of Goods Sold% is the most sensitive variable. When COGS% is decreased by 0.15%, the NPV will decrease form 427569.66 thousand dollars to zero. As we could see, project 2 is very risky. Besides, the upfront investment is also very sensitive. When it is increased by 17.01%, the NPV will be decreased to 0. According to upfront investment, there is 17.01% chance the NPV will drop below zero.

In conclusion, the company could consider investing on project2. As the analysis shown above, nearly all the indicators show that the project could be profitable to the company. However, project 2 is also very risky. The company should balance between profit and risk if investing on project 2.

Comparison between Project 1 and Project 2

Net Income comparison

It's given that is we adopt Project 1, Product Sales (Revenue) will grow 10% annually and the company has to invest 2500000; if we adopt Project 2, Revenue will increase 2.5% annually and the COGS will be reduced by 1%. It seems that Project 1 would be better since it has a much higher growth rate in Revenue, but the fact is, Net Income after Taxes of Project 2 is much higher than Project 1. The reason that Project 2 has higher Gross Profit and Net Income after Taxes is because of the reduction in COGS.

　

2011

2012

2013

2014

2015

Project

1

2

1

2

1

2

1

2

1

Revenue

119,572,200

111,419,550

131,529,420

114,205,039

144,682,362

117,060,165

159,150,598

119,986,669

175,065,658

COGS

113,328,600

104,545,634

124,661,460

107,159,274

137,127,606

109,838,256

150,840,367

112,584,213

165,924,403

Gross Profit

6,243,600

6,873,917

6,867,960

7,045,764

7,554,756

7,221,909

8,310,232

7,402,456

9,141,255

NIAT

1,367,300

1,985,913

1,504,030

2,035,560

1,654,433

2,086,449

1,819,876

2,138,611

2,001,864

Table2. Net Income Projection

Key Indicators comparison

NPV: NPV is an indicator of how much value an investment or project adds to the firm. As we can see in the Table above, Project 1 has a negative NPV and Project has a positive NPV. It means that if we adopt Project 1, it will end p subtracting value from the firm, but if we adopt Project 2, it will add value to the firm. That's a strong indicator for us to take Project 2 instead of Project 1.

IRR: IRR is the "annualized" rate of return that incorporates the time value of money. It's used measure and compares the profitability of investments. We should consider the project when its IRR is greater than the Cost of Capital. As we can see from the table above, IRR and WACC of Project 1 is -17.94% and 5.82% respectively, while the IRR and WACC of Project 2 is 15% and 8.51% respectively, suggesting that Project 2 is a much better project since its IRR is much greater than its WACC, while we shouldn't even consider Project 1 since its IRR is much lower than WACC.

PI: Profitability Index is the ratio of the present value of benefits to the present value of the costs. If the PI is greater than 1, it means it's worth considering the project, but if it's less than 1, we shouldn't consider it. As we can see from the table above, PI of Project 1 is 0.35, and PI of Project 2 is 1.17, suggesting that we should consider Project 2 and reject Project 1.

Payback Period: Payback period is the number of years that it will take a business to get back the money that it has invested in a project. As we can see from the table above, we can't get payback in payback if we adopt Project 1, but we can get payback in the fifth year if we adopt project two. It suggests that Project 1 is not worth considering.

EVA: EVA estimates the value created in excess of the required return. It's shown in the table that the EVA of Project 1 is negative in some years and positive in others, while EVA of Project 2 stays positive. That's why Project 2 is more preferable to Project 1 since there're no tough years in Project 2's lifetime.

Most Sensitive Factor: For project 1 and 2, the most sensitive factor is COGS. However, in Project 2, the NPV will reach 0 if the COGS increase 0.15%; in Project 1, the NPV will reach 0 if the COGS decrease 0.42%. It means that Project 2 has a lower tolerance, and Project 2 is more risky. Although Project 2 seems riskier, its NPV is positive and its COGS can still afford a 0.15% growth, while Project 1 has a negative NPV and it needs a 0.42% decrease to make its NPV 0. That means Project 2 is still more favorable over Project 1, but we have to carefully control COGS of Project 2 since even a slightest change could lead to dramatic variance in NPV.

EMV: There are equal chances that sales growth will be 7.5%, 15%, 10% for Project 1, and Project 1 got a negative EMV of -1522486.61, while that of Project 2 is positive 428594.13. So even from big scope and considering different Sales Growth, Project 1 is still not profitable. So from EMV point of view, Project 2 is favorable.

Conclusion

Base on our projection and analysis above, we can conclude that although Project 2 appears to be riskier than Project 1, it is also more promising from the financial point of view. It has greater return rate and can create more value for its investor. So we recommend the company to invest in Project 2 if the company has the confidence to control its COGS carefully.