Questions
1: Capital Budgeting
You are helping Initech with its capital budgeting decisions. The company is a producer and wholesaler of electronic parts, has a 14% cost of capital and is subject to a 30% tax rate. There are two major proposals on which Initech would like your advice.
1. The device part project
Initech is considering whether it should expand into production of a part for a new generation of mobile devices. Trends suggest these devices and their parts will offer high growth in the early years of a 5-year life cycle.
The new plant and equipment needed to produce the part will cost $800,000, which the business will depreciate for tax purposes using a prime cost rate of 10% per annum. When the project is wound up at the end of five years, the general purpose equipment is expected to be sold for an estimated $200,000. Sales in the first year are expected to be $4,000,000, increasing at a high rate of 10% in the second and third years and then falling by 15% per year for the last two years of the project as demand declines due to
competing new technologies. Consultants called in previously by Initech, who were paid $75,000 in fees, estimated that variable costs for the project will be 50% of its revenues.
Building rental, fixed salaries and other fixed costs directly related to the project are expected to be $1,500,000 in the first year and increase by 2% per year thereafter. The investment in net operating working capital related to the project is expected to be 10% of the following year’s sales revenues. This investment will be recovered by the end of the project. It is also thought that the project will encourage additional after tax profits of $150,000 per year for Initechs’ existing part range.
2. The conveyer system
Initech needs to install a conveyer system as soon as possible because the existing system, which has no scrap value, is beyond repair. Three different systems are being considered. The first, System A, is the same type of system as the old one – just a newer model. It will last 10 years and cost $40,000 to purchase and install. The second, System B, will last 10 years and cost $55,000 to purchase and install. The third, System C, will last 20 years and cost $130,000 to purchase and install. None of the systems will have any expected salvage value but all will be replaced at the end of their lives. After examining all costs, the net cash outflows for each system are: $13,000 per year for System A; $9,000 per year for System B; and $1,400 per year for System C.
2: Company analysis
For this question you are required to further analyse the ASX listed company assigned to you for Assignment
a) Briefly describe a likely “average” risk capital budgeting project for the company. Consider its possible life, cash flow pattern and investment size relative to the company. Also hypothesise the variables to which NPV might be most sensitive and would therefore need the most focus in project analysis. No quantitative analysis is needed to answer this question. Focus on qualitative factors. If the company has several business divisions, choose one for this question.
b) Assess the working capital management of your assigned company, focusing on its cash conversion cycle for each of the 30 June 2015 and 30 June 2016 financial years. Incorporate the company’s context within your evaluation and compare with a competitor or other relevant benchmark. As in Assignment 2, use DatAnalysis to access your assigned company’s financial data.1
3: Short-term financing
No additional research or data is necessary in answering this question. Simply apply your knowledge from the unit learning materials.
In its 2016 Annual Report, Telstra Corporation Limited stated that (p. 112): Our commercial paper is used principally to support working capital and short term liquidity.
a) What does the use of commercial paper suggest about the credit risk of Telstra?
b) What asset financing policy does the quote above suggest Telstra may follow? Justify your answer and outline the benefits of that policy in comparison with alternative policies.
Answers
1. Capital Budgeting:
Memo
From: XYZ Consultant
To: Initech
Re: Capital appraisal investment decision
We would like to acknowledge your decision to choose us as guidance for undertaking appraisal decision of your investment. You have provided with information about tow projects to be undertaken by you. First project is about device part and second project is about Conveyer system. Two proposals have been evaluated and analyzed in detail and they have been presented in the table in below section.
We have employed the techniques of capital budgeting where Net Present value tool is used to evaluate the projects. NPV of two projects will be calculated as difference between the initial investment made by the organization and present value of future cash flow of the project by using suitable discounting rate (Cavusgil et al. 2014). Calculation of NPV is done by using following formula:
Net present value = ∑ = Gt/ (1+k)t- Go
Where K denotes required or expected rate of return
t denotes for time duration of project
Go denotes preliminary capital investment made by Initech
Gt denotes flow of cash for period t
Decision rule for accepting or rejecting project:
Investor would accept the project if NPV is greater than 0 or it is positive. Project will be rejected if NPV is negative or less than zero and company will remain indifferent if NPV is equal to zero (Frank and Pamela 2016).
If we consider first project proposal of device part, the generated NPV in table is optimistic. This is so because value is positive. On other hand, considering project of conveyer system, table below depicts that NPV is negative. The negative value is for system B and C, however value is positive for system A. Therefore, as per acceptance criteria, project of device part and System B and system C of conveyer should be accepted and other should be rejected.
Evaluation and Analysis of financial data:
Project 1:
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Project 2:
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2: company analysis of Mantra Group limited
a) Average risk capital budgeting project of Mantra Group limited:
In this section researcher has selected Mantra group limited for analyzing the capital budgeting of project undertaken by company. Project is about expansion of divisions and stores in two other countries such as USA and UAE. Organization is planning to open eights new stores in these two countries. Capital budgeting involves both qualitative and quantitative analysis. However, researcher would concentrate of qualitative factors (Jindrichovska 2013).
The duration of project is assumed to be of eight years and criteria of accepting or rejecting project is determined by using techniques of capital budgeting. If the cost of capital high for computing future cash flow, then project is regarded risky. Another factor determining potentiality of project is degree of financial project. High proportion of debt in capital structure makes the financial degree of company higher. This would pose uncertainty in future cash inflow of any project.
b) Working capital management of company:
Working capital is calculated by collection data about current assets and current liabilities from annual report of two financial years.
2016 2015
Current assets= $ 177098000 $ 134185000
Current liabilities= $ 89342000 $ 89404000
Working capital for FY 2015= ($ 134185000- $ 89404000) = $ 44781000
Working capital for FY 2016= ($ 177098000 - $ 89342000) = $ 87756000
Working capitals for both years are positive. Working capital ratio for FY 2016 is 1.98 and for 2015, ratio is calculated to be at 1.5 (Annualreports.com 2017). From the figure, it clear that ratio has increased and this indicates that company has been efficient in converting its current assets into cash for meeting its current liabilities. Expansion of the group will be sustained by current growing operations. From this ratio, it is also evident that cash conversion cycle of company has increased as inventories are converted into sales at faster pace (Titman and Martin 2014). Therefore, cash conversion cycle of Mantra group Limited has also improved.
3:Short-term financing
a) credit risk of Telstra Corporation:
Telstra Corporation would experience increase in credit rating and enhancement of credit worthiness by employing commercial paper for financing their activities. Using commercial paper will change the perception of creditors and their likelihood of perceiving the risk of making default on part of company for meeting their obligations will reduced. Organization will experience an increase in their credit rating by credit agencies as it a low cost method for financing operations.
b) Financial policy Telstra Corporation:
The capital structure of Telstra Corporation id higher proportion of debt as compared to equity and hence the capital structure is more debt oriented. The business risk of the organization will be reduced by employing higher debt as this will increase financial leverage. Financial policy of Telstra Corporation encompasses three broad objectives. It comprise of maximizing value of shareholders, application of financial techniques while observing flexibility and increasing effectiveness of management concerning the feasible policy employment. However, employing of commercial paper has significant and influential role to play in reducing the credit risk of company (Petty et al. 2015). Gearing ratio can be depicted from graph below for which data have been collected from annual report.
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Debt to equity ratio of Telstra Corporation:
(Source: created by author)
From above graph, it is evident that Debt to equity ratio of Telstra Corporation have been computed to be at 121.2% and value of total debt to capital have calculated at 53.99%.
Capital structure of organization has been enhanced by employing commercial paper. If the proportion of equity in capital structure is high, then there is probability of generating higher return to shareholders with higher amount of risk. The financial policy has influenced and enhanced the profitability of organization. Nonetheless, it is essential for Telstra corporation to have right balance of equity and debt in their capital structure as this will assist in reducing the riskiness of business.
Reference :
Annualreports.com. (2017). Mantra Group Ltd - AnnualReports.com. [online] Available at: https://www.annualreports.com/Company/Mantra-Group-Ltd [Accessed 2 May 2017].
Bartlett, G., Beech, G., de Hart, F., de Jager, P., de Lange, J., Erasmus, P., Hefer, J., Madiba, T., Middelberg, S., Plant, G. and Streng, J., 2014. Financial Management: Turning theory into practice. OUP Catalogue.
Cavusgil, S.T., Knight, G., Riesenberger, J.R., Rammal, H.G. and Rose, E.L., 2014. International business. Pearson Australia.
Frank, J.F. and Pamela, P.P., 2016. Financial Management and Analysis.
Jindrichovska, I., 2013. Financial management in SMEs. European Research Studies, 16(4), p.79.
Petty, J.W., Titman, S., Keown, A.J., Martin, P., Martin, J.D. and Burrow, M., 2015. Financial management: Principles and applications. Pearson Higher Education AU.
Shapiro, A.C. and Moles, P., 2014. International financial management. John Wiley and Sons, Incorporated.
Titman, S. and Martin, J.D., 2014. Valuation. Pearson Higher Ed.
