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Risk And Return Analysis Capital Budgeting

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Question:

Discuss about the Risk and Return Analysis Capital Budgeting.
 
 

Answer:

Introduction

An investor earns returns from a stock in the form of dividend and stock price appreciation. For earning this return, he also has to undertake some amount of risk. Risk is the variability in the price of the stock over a period of time. Higher the risk of the stock, more is the expected return. An investor would undertake a risk return analysis before investing in a stock to see if the stock gives better returns than the market at a lower risk. We have done a risk return analysis for the Flight Centre Travel Group for a period of five years and on the basis of the results, have suggested whether it is a good investment or not.

Capital Budgeting is a process of determining the feasibility of a project comprising of long term investments in terms of profitability. Some of the capital expenditures include purchase of new plant and machinery, introduction of a new product or process etc. there are various techniques in capital budgeting which can be used to analyse the capital investment. Net present value (NPV) is the most important one and a project is accepted only if the NPV is more than 1. A capital budgeting analysis has been done for ABC ltd. where techniques used are NPV analysis, sensitivity analysis and scenario analysis.

Risk and Return Analysis

The daily returns, monthly returns and yearly returns and yearly standard deviation for the Flight Centre Travel Group are given in the annexure. The analysis has been done for a period of five years from 01-01-2012 to 31-12-2016. Also the systematic risk/market risk using the daily returns of the market has been calculated in the annexure along with the unsystematic risk (Yahoo. Finance, 2017)

On the basis of the above calculations, the beta value for the company’s stocks is 0.92. Beta measures the volatility of the stock with respect to the market and an investor can choose between various stocks depending on the beta and his risk appetite. A beta of 1 means that the movement in the stock price is in tandem with the market and if the market price increases by 10%, the stock price will also increase by 10%. A beta of less than 1 means the stock is more stable and does not move in tandem with the market. This reduces the risk of the stock. Here, Flight Travel Group has a beta of 0.92 which means that if the market price reduces by 10%, the stock price of the company will reduce by only 9.2%, thus implying low risk.

Hence, for investors who prefer a stable and secure investment, this is a good investment. However, investing only in this stock will not maximize the returns. In order to minimize the risks and maximize the returns, it is important to have a diversified portfolio. The market risk measured by beta or systematic risk cannot be fully eliminated but it can be minimized by diversifying the portfolio. Also the unsystematic risk which is the company specific risk is 1.7%. This risk can be eliminated with diversification. In a diversified portfolio stocks of different companies with different beta should be kept. Stocks with beta more than 1 will give high returns when the market is rising and stocks with beta less than 1 will give returns better than the market when the market is falling, thus maintaining a balance. Apart from stocks, an investor can invest in bonds which have very low risk and returns are assured (Damodaran, NA)

 

Capital Budgeting

Capital Budgeting is a process of analysing an investment expenditure to see if it is profitable to make such capital expenditure or not. There are various techniques to do so like NPV, IRR, payback period etc. The new expansion plant project of ABC Ltd. has been analysed using capital budgeting to see if the company should undertake the investment or not. 

The initial investment outlay of the project is:

Building cost

$24,000

Equipment

$16,000

Net working capital

$12,000

Initial investment

$52,000

The operating cash flows over the project’s life are given below:

Year

0

1

2

3

4

Annual sales

 

$80,000

$80,000

$80,000

$80,000

Variable manufacturing costs

 

$48,000

$48,000

$48,000

$48,000

Fixed overhead costs

 

$10,000

$10,000

$10,000

$10,000

Depreciation on building

 

$600

$600

$600

$600

Depreciation on equipment

 

$3,200

$3,200

$3,200

$3,200

Total operating income

 

$18,200

$18,200

$18,200

$18,200

Income Tax@40%

 

$7,280

$7,280

$7,280

$7,280

Profit after tax

 

$10,920

$10,920

$10,920

$10,920

Operating cash flows

 

$14,720

$14,720

$14,720

$14,720

The terminal year’s cash flows for the ABC’s expansion project:

Terminal value

After tax salvage value Building

$17,640

After tax salvage value equipment

$3,680

Recovery of working capital

$12,000

Terminal value

$33,320

Working Notes:

Building

Building cost

$24,000

Book value

$21,600

Total depreciation

$2,400

Annual depreciation

$600

Market value

$15,000

Loss on sale

$6,600

Tax on loss

$2,640

After tax salvage value

$17,640

Equipment

Equipment

$16,000

Book value

$3,200

Total depreciation

$12,800

Annual depreciation

$3,200

Market value

$4,000

profit on sale

$800

Tax on loss

$320

After tax salvage value

$3,680

NPV analysis

Year

0

1

2

3

4

Operating cash flows

 

$14,720

$14,720

$14,720

$14,720

Initial investment

-52000

 

 

 

 

Terminal value

 

 

 

 

$33,320

Net cash flows

-52000

$14,720

$14,720

$14,720

$48,040

Cost of capital @12%

$1

$0.893

$0.797

$0.712

$0.636

Present value of cash flows

-$52,000

$13,142.9

$11,734.7

$10,477.4

$30,530.3

NPV = $13,885

The project has a positive NPV which makes the project acceptable. A positive NPV means the cash inflows are more than the cash outflow and the project will generate profits for the company. Hence, it is recommended that the company should go ahead with the new plant expansion.

Sensitivity Analysis

It is a technique used to determine the NPV changes with a change in the various assumptions or estimates of the project. This helps the managers in a proper analysis and preparing them for the worst.

The result of sensitivity analysis for the current project by increasing and decreasing the sales, variable costs and cost of capital and their impact on the NPV has been discussed below:

Value Drivers

Expected NPV

Revised NPV

% Change

Increase in sales by 2%

$13,885

$15,052

8.4%

Increase in sales by 5%

$13,885

$16,801

21.0%

Increase in sales by 10%

$13,885

$19,717

42.0%

Decrease in sales by 2%

$13,885

$12,719

-8.4%

Decrease in sales by 5%

$13,885

$10,969

-21.0%

Decrease in sales by 10%

$13,885

$8,054

-42.0%

Increase in variable costs by 2%

$13,885

$12,136

-12.6%

Increase in variable costs by 5%

$13,885

$9,511

-31.5%

Increase in variable costs by 10%

$13,885

$5,138

-63.0%

Decrease in variable costs by 2%

$13,885

$15,635

12.6%

Decrease in variable costs by 5%

$13,885

$18,259

31.5%

Decrease in variable costs by 10%

$13,885

$22,633

63.0%

Increase in cost of capital by 2%

$13,885

$10,618

-23.5%

Increase in cost of capital by 5%

$13,885

$6,162

-55.6%

Increase in cost of capital by 10%

$13,885

-$253

-101.8%

Decrease in cost of capital by 2%

$13,885

$17,418

25.4%

Decrease in cost of capital by 5%

$13,885

$23,279

67.7%

Decrease in cost of capital by 10%

$13,885

$34,832

150.9%

From the above table we see that cost of capital is the most sensitive factor in this project as with a 10% increase in the cost of capital, the NPV decreases by more than 100%. Also with a decrease in cost of capital by 10%, the NPV increase by 150%, thus making it the most sensitive factor. After cost of capital, it the variable cost which is sensitive to the NPV. With 10% increase in variable costs, the NPV decreases by 63% whereas with a 10% decrease in sales, the NPV decreases only by 42%. Thus cost of capital is the most sensitive factor followed by variable costs and the least sensitive is sales.           

Scenario Analysis

Under scenario analysis, different scenarios are taken where more than 1 input is altered and the impact of such changes is seen in the NPV. Normally there are three scenarios considered which is best case, normal case and worst case.

For the current situation, we have assumed the best case as increase in sales by 10%, decrease in variable costs by 10%, and decrease in cost of capital by 10%. For the worst case we have assumed decrease in sales by 10%, increase in variable costs by 10%, and increase in cost of capital by 10%. The results are as follows:

 

Original NPV

Revised NPV

% Change

Best Case

$13,885

$54,206

290.4%

Normal case

$13,885

$13,885

0.0%

Worst case

$13,885

-$11,504

-182.9%

From the above table we see that the NPV increases by 290% in the best case and decreases by 183% in the worst case.

Conclusion

The risk and return analysis of Flight Centre Travel Group suggests that the stock is a safe stock with a beta less than 1 (0.92) and hence is a good investment for investors with low risk appetite. However, in order to maximize returns, it is suggested that the investor should invest in stocks of other companies with a beta of more than 1. This will diversify his portfolio. Also apart from stocks, he should invest in other securities like bonds and debentures.

The capital budgeting analysis of ABC Ltd. new plant expansion project gives a favourable result where the NPV is positive and the project seems favourable. Of all the inputs, cost of capital is the most sensitive factor.

 

Reference

Damodaran, A., (NA), Estimating Risk Parameters, Stern School of Business, New York

Finance. Yahoo, (2017), S&P/ASX 200 (^ AXJO), accessed online on 17th April, 2017, available at https://in.finance.yahoo.com/quote/%5EAXJO?ltr=1

Finance. Yahoo, (2017), Flight Centre Travel Group Limited (FLT.AX), accessed online on 17th April, 2017, available at, https://finance.yahoo.com/quote/flt.ax?ltr=1

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