Report For Reinaldo Products New Investment Under Consideration Finance Essay
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1) Should Reinaldo focus on cash flows or accounting profits in making our capital-budgeting decisions? Should we be interested in incremental cash flows, incremental profits, total free cash flows, or total profits?
When undertaking a new project an organisation usually uses Capital Budgeting Techniques which gives a better understanding of the outcome of the project to the management by taking management decisions accordingly.
Let us first understand what Capital Budgeting is:
Capital Budgeting can be understood as a process or technique by which a financial manager or analyst can understand which amongst the different projects will earn the highest yield during the life of the project. It is a process which helps the management to determine if a project (e.g. buying new machinery or plant, replacement of machinery or investing in research and development) is worth investing. Companies always have ideas for many projects hence Capital Budgeting helps them select the best project with highest returns.
While making capital budgeting decisions Reinaldo has to focus on cash flows however accounting profits also can be focused. However more weightage has to be given to cash flow. The movement of money in and out of a business is known as Cash Flow. The financial health of an organisation is measured by cash flow. Cash flow helps to determine the liquidity of an organisation, even though the firm is profitable it need not be liquid enough and can result in its failure due to shortage of cash. Preferably managers should make capital budgeting decisions based on Incremental Cash Flows and by discounting them to find out their present time value of money. Positive incremental cash flow states that there will be an increase in the cash if the project is undertaken.
Accounting Profits is another area of focus as it shows the total earnings of the project to be undertaken. Any project whose profits will be below the organisations required rate of return cannot be undertaken, therefore adequate focus has to be made on the forecast of the projects impact on its financial statements and the earnings it will provide to its stakeholders. As the project is supposed to be terminated after 5 years, we will have to take decisions based on Incremental profits. The profits will increase as long as the incremental profit is more than the incremental costs.
2) How does depreciation affect free cash flows?
Depreciation is a non cash expense used in accounting which reduces the value of a tangible asset due to the asset's wear and tear. Depreciation being a non cash expense reduces the total net earnings of an organisation hence resulting in the reduction of the total tax payable by the firm.
While preparing free cash flows depreciation is first deducted from the earnings and then tax amount is calculated (i.e. the total tax amount payable by the organisation reduces), depreciation being a non cash expense is then added back again to the free cash flow statement. This means that depreciation does not directly affect free cash flow but has an indirect affect on the same as it reduces the cash outflow of tax payable.
Table 2.1 showing the effect of depreciation on Free Cash Flow
Earnings before Depreciation, Interest and Tax (EBDIT) ( - ) Depreciation = Earnings before Interest and Tax ( - ) Tax ( + ) Depreciation = Operating Cash Flow ( - ) Incremental Working Capital ( - ) Capital Investment = Free Cash Flow
3) How do sunk costs affect the determination of cash flows?
The money which has already been spent but cannot be recovered is termed as Sunk Costs and is also known as Stranded Costs. These costs are incurred before an activity hence it is an outflow in the cash flow statement. A huge sunk cost can make an investment irreversible. A high sunk costs effect on the cash flow is significantly larger than those with low sunk costs. It is not possible to undo the a cash flow outflow which has incurred sunk cost, hence only the costs incurred in the future will be relevant as these cash disbursements can be controlled.
4) The Project's Initial Outlay
Initial outlay is the initial net investment required for starting up a new business or a new project. The net cost which a will be incurred by the organisation for the start up of a new business or a new project is called as the project's initial outlay. The initial outlay of a project not only includes land & building, plant and machinery but also includes the initial working capital required at the commencement of the project.
For Reinaldo its project's initial outlay will include:
Cost of Plant and Equipment.
Shipping and Installation Costs.
Initial Working Capital required.
The above table shows that the Reinaldo's total project initial outlay is $8,100,000 /-
5) The Differential Cash Flows over the project life
Differential Cash flow is the Free Cash Flow of a project after taking into account the changes in its revenue, operating expenses, taxes, depreciation and incremental working capital excluding terminal cash flow. The Differential cash flows of Reinaldo's project over its life of 5 years can be seen in the below tables.
6) The Terminal Cash Flow
During the termination of a business or a project the net sale proceed of the firm's assets, taxes related to capital gain and the release of its initial outlay towards the working capital is known as Terminal Cash Flow.
At Reinaldo Products there is no salvage value of its plant and equipment hence only the realisation of its working capital will be its terminal cash flow.
Therefore the Terminal Cash flow of Reinaldo Products = $ 1,560,000/-
Table 6.1 below shows the calculation of its Working Capital as for Reinaldo only its liquidated Working Capital will be its Terminal Cash Flow.
7) The Cash Flow Diagram for this Project
Cash Flow is one of the financial statements which shows the relationship between the net income and changes in cash balances, it reports the cash receipts and the cash payments for a particular period.
A Cash Flow Statement is prepared under the following headings:
Cash Flow from Operating Activities
Cash Flow from Financing Activities
Cash FLowfrom Investing Activities
Cash Flow Diagram is a graphical representation showing the closing balances of the firm's cash flow statements which is the net inflow or the net outflow of cash.
8) The Net Present Value.
Net Present Value or NPV is the valuation of a project's present value of cash inflows with the difference of its present value of cash outflows. It is done by discounting the cash flow balances of the future periods to its present value and by deducting the initial investment. This is done by taking into consideration inflation and returns into account as the worth of a dollar at present will be much higher than the worth of it in the future.
NPV plays a very important role in the capital-budgeting process for an investment or project to be undertaken as it recognises the Time Value of Money for the investment and its required rate of return.
The decision rules of NPV are as below:
When NPV > 0 - The project can be Accepted (Return is greater than the required Rate)
When NPV = 0 - The project is Acceptable (Return equal to Required Rate)
When NPV < 0 - The project is Rejected (Return is less than the required Rate)
The Calculation of NPV can be done as per the below formula:
Net Present Value (NPV)
As per the given project at Reinaldo and taking its forecasted cash flows for the 5 years of the project life with the Required Rate of Return being 15% the NPV for the project under consideration for Reinaldo Products is $ 16,744,053 /-
NPV can also be calculated using an Excel spreadsheet as solved in Table 8.1.
The Internal Rate of Return
Internal Rate of Return or IRR is the rate of return or the discounted rate which makes the present value of the cash flows equal to its initial outlay. In other words IRR is when the discount rate used in Capital Budgeting forces the Net Present Value (NPV) of all its cash flows for a proposed project to be equal to zero (NPV= 0). IRR is also known as Economic Rate of Return (ERR)
IRR is most frequently used in Capital Budgeting to determine if the project is worthy enough to be undertaken.
The decision rule if IRR is as below:
If IRR >= required rate of return - The project is Accepted.
If IRR < required rate of return - The project is Rejected.
IRR can be calculated by using the below formula
\mbox{NPV} = \sum_{n=0}^{N} \frac{C_n}{(1+r)^{n}} = 0
As per the given project at Reinaldo and taking its forecasted cash flows for the 5 years of the project life its IRR can be calculated as below:
Where, r = internal rate of return, when NPV is zero
Putting r = 75 % NPV = 218
When r = 80% NPV = (-) 305
When r = 77.02 % NPV = 0 (approximately)
Therefore Internal Rate of Return (IRR) = 77.02 %
10) Acceptance of Project? Why or Why not?
After the preparation of all the forecasted future cash flows and keeping in mind the internal rate of return(as done above), to come to a final decision whether an investment should be undertaken or not the decision needs to be based on the below mentioned Capital Budgeting Techniques:
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)
a) Net Present Value (NPV) - The NPV of the given project is $ 16,744,053 which is greater than 0
b) Profitability Index (PI) - The PI of the project is 2.067
c) Internal Rate of Return (IRR) - The IRR of the project is 77.02 %
The above project will be ACCEPTED as it is meeting all the rules of NPV, PI and IRR.
NPV is $ 16,744,053 which is greater than 0
PI is 2.067 is also greater than 0
IRR is 77.02 % and is again meeting the rule for accepting the project. IRR being 77.02 % making the NPV of the cash flows to be equal to 0.
The Return of the project is much higher than the Required Rate of Return of Reinaldo Products.
11) Other two Investments with one-year lives.
a) Calculation of Net Present Value (NPV)
NPV = (Investment) + Cash Flow* PVIF(r, n)
NPV for Project A
= (195,000) + 240,000 * PVIF (10%, 1)
= (195,000) + 240,000 * 0.9091
= (195,000) + 218,184
=$ 23,184
NPV for Project B
= (1,200.000) + 1,650,000 * PVIF (10 %, 1)
= (1,200,000) + 1,650,000 * 0.9091
= (1,200,000) + 1,500,015
= $ 300,015
Hence the NPV:
Project A - $23,184
Project B - $ 300,015
c) Calculation of Internal Rate of Return
IRR is when: \mbox{NPV} = \sum_{n=0}^{N} \frac{C_n}{(1+r)^{n}} = 0
IRR for project A
Where, r = internal rate of return, when NPV is zero
Putting r = 20 %, NPV = 5000
When r = 25 %, NPV = (-) 3000
When r = 23.07 %, NPV = 0 (approx)
IRR for Project B
Where, r = internal rate of return, when NPV is zero
Putting r = 35 %, NPV = 22,222.22
When r = 40 %, NPV = (-) 21,428.5
When r = 37.5 %, NPV = 0
Hence the IRR:
Project A - 23.07
Project B - 37.5
d) If there is no capital - rationing constraints, which project should be selected? If there is a capital - rationing constraint, how should the decision be made?
Capital Rationing is when a company limits or restricts the amount to be invested in its new project. Capital Rationing is imposed by the companies by either imposing a higher cost of capital or by setting a ceiling on specific sections. The reason behind imposing capital rationing can be because a certain company might have generated lower returns than their expected required rate in their past investments.
If Reinaldo faces no capital- rationing then it should choose Project B as its NPV is very high at $ 300,015 also its PI and IRR are positive with 0.25 and 37.5 respectively.
However if the company has excess of reserves and has an option of not having to choose only one project between the two, then it can even invest in both the projects as both the projects will provide returns higher than their required rate of return.
If there is capital - rationing constraint then it is better to invest in Project A as it provides good returns with lower investment. The capital investment of project A is $195,000 which is $1,005,000 less than that of project B. Also with lesser investment project A's NPV, PI and IRR is 23,148, 0.12 and 23.07% respectively which means that the rate of return is much higher than the company's required rate of 10 %.
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