Capital Budgeting and Valuation Techniques for Investment and Financing Decisions

Firm's Investment Decisions

Purpose Investment decision and financing decision are vital to the survival of a business. The purpose of this assessment is to explore some advanced Capital Budgeting and Valuation techniques introduced in this subject to help make such decisions. Context In this activity, you will apply the time value of money techniques to evaluate the organisation investment and financing options as given below. This activity assesses your understanding and application of the material you have learnt in Weeks 1-3 (Topics 1-5). Firm's investment decisions Suppose you are working as an external capital budgeting advisor to a highly successful manufacturing firm. You have recently received a proposal for equipment replacement that will presumably lead to more capacity and less cost. The replacement details and their effect on the company are given below. Old Equipment New Equipment Current book value $400,000 Current market value $600,000 Acquisition cost $1,000,000 Remaining life (years) 10 Life (years) 10 Associated annual sales $300,000 Associated annual sales $450,000 Associated operating expenses $120,000 Associated operating expenses $150,000 Annual depreciation $40,000 Annual depreciation $100,000 Accounting salvage value $0 Accounting salvage value $0 Expected salvage value $100,000 Expected salvage value $200,000 If the new equipment replaces the old equipment, an additional investment of $80,000 in net working capital will be required, which would be fully retrieved at the end of 10 years. The corporate tax rate is 30% and the required rate of return is estimated to be 10% for your company. As you work through the NPV and IRR analysis provided by the company, you discover the following errors (common pitfalls to avoid): Error 1: The initial outlay correctly accounts for incremental investment in new fixed capital and net working capital, but after-tax cash proceeds from the sale of old fixed capital are not adjusted. Error 2: Annual operating cash flows are not adjusted for tax, and depreciation is not added back. Error 3: Terminal-year cash flows do not recapture investment in net working capital. Also, incremental capital gains on salvage value are not taxed. You realise that you need to do the entire project feasibility report from scratch, and you believe using a spreadsheet will be very helpful for this exercise. Firm's financing decision Suppose the company requires finance for the above investment decision. Company is currently holding a portfolio of the so-called FAANG stocks: Facebook, Amazon, Apple, Netflix, and Google (now Alphabet) (Reinicke 2020). The firm is considering selling part of this portfolio to finance the above project. To make this decision, the company is struggling to value these shares and need your assistance. Assessment questions The following questions should be addressed in this assignment: Find out the NPV, IRR and profitability index for the replacement proposal. What do these criteria say about the replacement? Begin the report by briefly explaining the capital budgeting methods. Explain why these criteria are considered superior to the accounting rate of return and payback period used by some firms. Some estimates are subjective and may be prone to judgement error or uncertainty. For this reason, please conduct a sensitivity analysis of NPV to the required rate of return falling between the range of 10% to 16% pa (with increments of 1%) for the replacement proposal. Discuss the implications. Using one relevant valuation method (Valuation by comparable or free cash flow) introduced in topic 3 of this subject, calculate the theoretical price of each FAANG stock. Explain the method chosen for the calculations, critically discussing the assumptions and validity of your result. Compare the theoretical price with the current market price and explain the reasons behind the differences observed. Which stock should the firm sell to arrange the finance and why? Summarise your findings, discuss any limitations of your evaluations and present your recommendations. References Reinicke, C 2020, 'Nearly every FAANG stock hits a record high as the rally in mega-cap tech continues', Business Insider Australia, viewed 13 September 2020, https://www.businessinsider.com.au/facebook-apple-amazon-netflix-faang-stock-prices-record-high-rally-2020-7?r=US&IR=T. Requirements The required word length for this assessment is 2,500 words (plus 10% tolerance). The list of references is required to contain at least 6–10 relevant references from different reputable sources, such as books, industry-related journals, magazines, company documents and recent academic articles.