i) Cash flows of new project
Details / year
0
1
2
3
4
Gross turnover
1,750,000
3,250,000
5,250,000
6,250,000
Less direct costs
1,500,000
2,300,000
3,100,000
3,300,000
Marketing costs
300,000
450,000
400,000
400,000
Office overhead (50%)
125,000
125000
125000
125000
Net profit before tax and depreciation
(175,000)
375,000
1,625,000
2,425,000
Less Taxation (shield)-33%
(57,750)
123,750
536,250
800,250
Net profit before depreciation tax shield
(117,250)
251,250
1,088,750
1,624,750
Depreciation tax shield (w1x(1- tax rate))
167,500
125,625
94,219
69,610
Net cash inflow
50,250
376,875
1,182,969
1,694,360
Land and building
(5000,000)
Fittings and equipment
(1,000,000)
Working capital outflow
(500,000)
(100,000)
(150,000)
(50,000)
Disposal of investment
10,527,414
Net cash flows
(6,500,000)
(49,750)
226,875
1,132,969
12,221,774
Adjustment for inflation
(51,740)
235,950
1,178,288
12,710,645
Certainty equivalent
0.90
0.85
0.80
0.75
Certain cash flows
(6,500,000)
(46,566)
200,558
942,630
9,532,984
PVF 18.56%
1
0.843
0.7114
0.600
0.506
The present value
(6,500,000)
(39,255.)
142,676
565,578.
4,823,690
The net present value for the project is = (6,500,000) + (39,255) +142,676+ 565,578+4,823,690 = (1,007,311)
Using a discount rate of 18.56% which is a nominal rate and nominal cash flows calculated above. The net present value is negative 1, 007,311. Using this criteria the project should be rejected as it gives a negative present value which will reduce the shareholders funds. The net present value obtained shows that the business should not invest the 6.5 million as they will not gain anything. Instead they will lose. However further analysis should be carried out using Internal Rate of Return as well as modified internal rate of return.
(ii) In real life appraisal of investment project differs from the example used above. The example above used assumes that the cash flows occur at year end. But in real sense this is not the case, they tend to spread throughout the year. If this consideration is taken you may find that a project is acceptable because of the timing of cash flows. In this case it only assumed that cash flows occurred at the end of the year which was a bias and these cash flows were estimated with some certainty through the certainty equivalent factor. However in real practice cash flows cannot be estimated with such things as certainty equivalent factor which calls for sensitivity analysis. Sensitivity analysis analyses how sensitive are a certain element associated with the project.
(iii) There are many factors that should be taken into consideration by the board before deciding whether to undertake the investment. One of factors that should be considered is the financing of the project. Financing plays an important role in project management. Especially these times of financial crisis the type of finance to be sourced for the project is of paramount importance. The management also should consider risk associate with the investment. They should consider the risks inherent in the business such as competition management and analyze to gauge whether they are capable if undertaking the project. The government policy economic conditions and environmental risks should also play an important role before making a decision. Suppose the company was intending to manufacture and supply goods to a country that is politically unstable. The political risk associated with the instability should be in consideration before making the decision. The company should also consider the ability of companies with similar products to enter into the market thus destroying the company’s market.
(iv) in this case there are various sources of finance and each has its own features and suitability.
Equity capital.
In this case equity capital will be the safest method of raising capital but the cost of raising this capital will be high. This source of capital will dilute the management control and may end up introducing new ideas to the business by injecting new people as shareholders. Other characteristics for this source of financing include it is risky to the shareholders but with low risk to the firm. They attract dividends which are not tax deductable, they can be liquidated in the market if the company opts to register in the stock exchange.
Short -term borrowing.
Short term borrowing has many advantages to this organization. This form of capital has an interest rate of 8.5 % which is fixed and it attracts interests.
Short -term is a form of financing whose period of repayment is up to one year.
Medium – term is a form of financing from one year to seven years. This form of financing is best when the finance raised is to meet a specific current requirement, which is not expected to continue indefinitely.
Advantages (McLane E, 231-232)
(i) They are risky since they can be paid on demand or within the stated period and normally the duration is short whereas others can be terminated any period depending on the financial position of the company for example bank overdrafts and loans.
(ii) During winding up of the company, they are given last priority since they are not secured.
(iii) They have no voting rights in the company’s general control.
(iv) Flexibility – they can be sued as required for instance bank overdrafts can be sued so long as the company does not exceed the required limit. In addition, credit period can be extended depending on the goods or services supplied.
(v) Liable – any company can easily access this facility so long as it meets the requirements.
(vi) Not expensive – interest rates are usually above the base rate and are tax deductible.
Disadvantages
(i) Risky since they are legally repayable on demand or within a certain stated period depending on the financial position of the company.
(ii) Security is usually required by way of fixed or floating charges on assets or sometimes in private companies by personal guarantees from owners.
(iii) Interest costs vary with bank base rates.
Long-term debt
This is a form of loan capital that is payable on long basis. This includes;
(i) Debentures: Is a written acknowledge of a debt by a company containing provisions of interest and the terms of repayment of principal. This can be secured, unsecured, irredeemable, or redeemable. Secured debt will carry charge on one or more specific assets or all assets of the company such that on default of repayment of interested principal, the debenture holder will appoint receive to administer the assets until the interest is paid eventually they can sale the asset to repay the principal. Redeemable debt is where the principal is repayable at a specified future date whereas irredeemable is the opposite.
(ii) Preference share: Is a form of financing whereby shareholders are paid a fixed rate of dividend after creditors but before ordinary shareholders. This can be Cumulative preference shares where shareholders are paid a fixed amount of dividends and arrears accumulate. Non-cumulative where they receive a fixed rate of dividend but arrears does not accumulate (McLaney E 228-229).
Advantages
(i) Cheap – because is less risky, debenture holders can accept a lower rate of return.
(ii) Cost is limited to the stipulated interest repayment.
(iii)There is no dilution of control where debt is offered since no voting rights.
Disadvantages
(i) Interest is a compulsory default will mean selling the company securities or the company will go under receivership.
(ii) It is limited since the shareholders are concerned that a geared company can not pay its interest and still pay its dividend and raise the rate of return that they require from the company to compensate for this risk.
(iii) Provision must be made for the repayment of debt with fixed maturity rate.
(iv) If the general interest rates fall, fixed rate interest payments may prove to be a burden.
References
Ghetti A., Terrific introduction to financial management; Amazon, 2008 pg218-223
Gitman L.J. Principles of financial management; Harper and Bow; 1994 pg 368-374
Luecke R; (2002) Finance for Managers; Harvard Business School Press;
McLaney E., Business finance theory and practice; Prentice Hall, 2003 pg 218-237
Westerfield R., Jaffe, and Jordan (2007); Corporate finance core principles and applications by McGraw-Hill. ISBN-13: 978-0-07-353059-8/ISBN-10:0-07-353059-X
Winger and Frasca Personal Finance An Integrated Planning Approach, Pearson
Appendix
Workings 1-depreciation
Year 1 depreciation = 1000, 000x 25% = 250,000
Written down value = 750,000
Year 2depreciation = 750,000x 25% = 187,500
Written down value = 562,500
Year 3 depreciation = 562,500 x 25% = 140,625
Written down value = 421,875
Year 4 depreciation = 421,875x 25% = 105,469
Written down value = 316,406
Workings 2 fourth year post tax profits
Revenue 6,250,000
Direct costs (3,300,000)
Marketing costs (400,000)
Office overhead (250,000)
Depreciation (105,469)
Accounting Profit before tax 2,194,531
Taxation 33% 724,195
Post tax profit 1,470,336
Workings 3- disposal value
Book value of furniture and fitting 316,406
Land and building 5,000,000
Working capital 800,000
Post tax profit 1,470,336×3 4,411,008
Sub total 10,527,414
Working 4: effective discount rate
1+rn =(1+rr)(1+i)
Where rn is the nominal rate of interest,
Rr is the real rate of interest,
I is expected inflation rate.
Therefore it is 1+rn =(1+0.14)(1+0.04)
1+ rn= 1.1856
Rn=18.56%
Working 5: Capital structure
Assuming the current capital structure is optimal. The new capital that will be raised will be the initial cash capital in year zero. This capital is totaling to 6.5 million as per the schedule of cash flows above. The weighted average cost of capital that will be used in analyzing this project will be calculated based on the cost of this new capital to be raised. The following are schedules for calculating the weighted cost of capital for the new source of capital. The capital structure currently is as follows:
Capital
Book value
proportion
Equity capital
50,000,000
0.714
Debt capital
20,000,000
0.286
Total
70,000,000
1.000
