Proposal 1- Device Part Project
In order to conduct the analysis of the new device project, various information has been provided which has been summarized below.
- The new equipment and plant would cost $ 800,000 at the start of the project.
- It is estimated that the project would be closed after five years and the remaining value of the new equipment and plant would be $200,000.
- Considering that the project would be scrapped after 5 years, it may be concluded that the duration of the project is only 5 years even though the plant and equipment has a useful life of 10 years.
- The depreciation charged on the plant and equipment is using the straight line method with an estimated life of 10 years.
Thus, depreciation expense on an annual basis = (1/10)*($800,000) = $ 80,000
- Considering the above depreciation carrying value of the equipment at the end of the 5th year = Initial Purchase Price – Accumulated Depreciation = 800000 - (5*80000) = $ 400,000
However proceeds on sale as listed above = $ 200,000
Thus, loss on disposal of the equipment = (400000 -200000) = $ 200,000
This amount would be reflected in the income statement and would lead to lower tax liability for the company (Damodaran, 2010).
- The incremental sales generated during the first year would be $ 4,000,000 which first would undergo an increase for the year 2 & 3 before undergoing a decrease for the year 4 & 5.
- The variable costs which would be incurred for this would amount to 50% of the total extra revenues generated.
- There would be fixed cost associated with the project to the tune of $ 1.5 million which would keep on increasing at the rate of 2% per annum.
- Also, incremental working capital would be required to be incurred at the rate of 10% the expected revenues for the next year but by the project end, it will be recovered.
- The consultant cost would be disregarded for the project appraisal as it has been spent by the company already and hence will be categorized as sunk costs (Ross, Trayler & Bird, 2007).
- The rate of tax is known to be 30% while the cost of capital stands at 14%.
For taking a decision in regards to whether the given project should be proceeded with or not, the NPV computation needs to be performed that has been carried out below (Brealey, Myers & Allen, 2012).
The various assumptions that have been taken for the above computations are summarized below (Damodaran, 2010).
- There would be liquidation of the plant and equipment when five years are over and the price obtained would be equal to the salvage value.
- The working capital can be recovered before the end of the project if it is in surplus of the 10% of the next year revenues.
- The various cash flows associated with revenue and costs would all be incurred in a lump sum payment at year end which is critical for the discounting treatment used in the computation above.
The computation carried out above clearly suggests that the NPV of the new device project comes out as positive which indicates that the project is financially feasible and would create significant value for the shareholders. As a result, the company should go ahead with the project (Ross, Trayler & Bird,2007).
Proposal 2- Conveyor System
In accordance with the given information, the objective is to analyze the three systems namely A, B,C in light of the quantitative data presented so as to opine on the system which must replace the existing system. It is noticeable that the economic life of project A and B is 10 years each but for project C, the corresponding value is 20 years. Hence, it is imperative to compute the Equivalent Annual Annuity(EAA) to carry out an objective comparison and offer prudent recommendation (Brealey, Myers & Allen, 2012).
Setup cost = $ 40,000
Useful life = 10 years
Expected cash outflows on an annual basis = $ 13,000
Cash outflows considering a tax rate of 30% = (1-0.3)*13000 = $ 9,100
NPV = -9100(1-1.14-10)/0.14 -40000 = -$ 97,467
EAA = -$ 97,467*0.14/(1-1.14-10) = -$ 18,686
Setup cost = $ 55,000
Useful life = 10 years
Expected cash outflows on an annual basis = $ 9,000
Cash outflows considering a tax rate of 30% = (1-0.3)*9000 = $ 6,300
NPV = -6300(1-1.14-10)/0.14 – 55000 = -$ 87,862
EAA = -$ 87,862*0.14/(1-1.14-10) = -$ 16,844
Setup cost = $ 130,000
Useful life = 20 years
Expected cash outflows on an annual basis = $ 1,400
Cash outflows considering a tax rate of 30% = (1-0.3)*1,400 = $ 980
NPV = -980(1-1.14-20)/0.14 -130,000 = -$136,491
EAA = -$ 136491*0.14/(1-1.14-20) = -$ 20,608
On the basis of EAA computations that have been carried out above, it is evident that least equivalent annual outflow would be experienced in system B and as a result it must be selected to replace the current system (Ross, Trayler & Bird,2007).
a. A project with average risk keeping in mind the business profile of the selected company Jb Hi Fi would involve opening of a store with a initial lease of 3 years with a clause to extend the same by another term if business is profitable. In the time leading up to the opening of the store, there would be sizable cash outflows involved in opening the store and promoting the same but on an operational basis, it would be fair to expect that positive cash flows are realized after about 6 months. The investment assumed for the store coupled with working capital requirement for 6 months is expected to be $ 1 million. The project NPV is contingent on a host of factors ranging from the macroeconomic parameters impacting consumer confidence, disposable income levels of the customers, quality of service given to customers and the competitive landscape. Favorable macroeconomic data tends to enhance the potential of the project being successful while an adverse macroeconomic may hit the consumer confidence and lead to difficult periods especially during the first one year (Brealey, Myers & Allen, 2012).
b. Cash conversion cycle for JB-Hi- Fi in 2015 = 35.70 days (Mornignstar, 2017a)
Cash conversion cycle for JB-Hi- Fi in 2016 = 36.02 days (Mornignstar, 2017a)
Cash conversion cycle for Harvey Norman Holdings in 2015 = 41.89 days (Mornignstar, 2017b)
Cash conversion cycle for Harvey Norman Holdings in 2016= 41.74 days (Mornignstar, 2017b)
The values for the cash conversion cycle for the selected company Jb Hi Fi indicate a marginal increase in the cycle duration in 2016 in comparison to 2015 which is in contract to the decreasing cycle witnessed for Harvey Normal during the corresponding period. The above trend is favorable for Harvey since the decrease in cash conversion cycle would ensure that the company would have lower financing needs particularly in relation of funding the working capital requirements. The drop in the quantum of debt assumed lowers the leverage of the company and improves the balance sheet health besides enhancing the overall profits by lowering the interest paid to the lender on a regular basis (Damodaran, 2010).
Commercial papers refers to a unsecured instrument of debt which companies used to raise financing over the short term. Taking into consideration, the fact that Telstra uses this as the financing medium for short term financial needs, it indicates that the credit rating it has would be high which is why it manages to garner unsecured debt at competitive rates (Damodaran, 2010).
The given statement in context of the company is indicative of the company’s flexibility in choosing the appropriate financing media based on the underlying usage which is associated with the principle of matching maturity. This is a flexible financing strategy which is non-committal to any particular financing means as it realizes the perils of both financing and also advantages of both short term and long term financing and uses the means that fits the maturity period of the expected use (Ross, Trayler & Bird, 2007).
The alternate options in this regards are as follows (Brealey, Myers & Allen, 2012).
- Non-current Debt – It causes high interest charges when the same is used for financing short term debt and hence it suitable only for long term debt.
- Current Debt – For financing long term debt through short term debt would involve periodic refinancing which might involve extra cost coupled with operational hassles and thus more suitable for short term debt.
Considering the above, it is prudent to conclude that the financing policy based on matching principle allow the company to reap the best of both policies.
Brealey, R. A., Myers, S. C., & Allen, F. (2012). Principles of corporate finance, 2nd edn.. New York: McGraw-Hill Inc.,US.
Damodaran, A. (2010). Applied corporate finance: A user’s manual, 3rd edn.. New York: Wiley, John & Sons.
Morningstar (2017a), JbHiFi Limited, [Online] Available at https://financials.morningstar.com/ratios/r.html?t=JBH®ion=AUS&culture=en_US [Accessed May 05, 2017]
Morningstar (2017b), Harvey Norman Holdings Ltd- HVN, [Online] Available at https://financials.morningstar.com/ratios/r.html?t=HVN [Accessed May 05, 2017]
Ross, S. A., Trayler, R., & Bird, R. (2007). Essentials of corporate finance, 3rd edn.. Sydney: McGraw-Hill Australia.