5 financial questions Essay Example

Executive summary

When implementing capital intensive projects, companies usually consider a variety of factors in a bid to ensure that the project is only implemented if it is in line with the company’s business strategy and hence viable. The factors considered may be financial, technical, social and environmental. This report presents an analysis of a juice bottling project by Dragon Food industries. This has been done using NPV analysis. The report has considered different scenarios under different rates of inflation, demand and level of risk. In conclusion, the report concludes that the company should go ahead with the project. However, it is suggested that the company assures itself that various factors including inflation, level of demand and risk remain as anticipated if the project is to create value for the shareholders and hence remain viable.

Introduction

Before an organization can embark on implementing any project, it ought to assure itself that the project will be viable both technically and financially. Other factors to be considered should include the effect that the project is likely to have socially and environmentally (Halil, 2011). Among the financial factors to be considered should include the availability of markets for the new products, inflation and the rate of risk that the company is willing to assume by investing in the project. This report is aimed at guiding the CEO and the management of Dragon Food Industries on whether or not to invest in a juice bottling project given the rate of inflation, the discount rate and the market demand for the new product.

Project’s viability

Initial investment

Consultancy fees $12,000

Building $750,000

Machine $300,000

Installation cost $50,000

Rise in working capital $25,000

$1,142,000

Annual equipment depreciation

Equipment cost $300,000

Installation cost $50,000

Amount to be depreciated $350,000

Depreciated over 7 years

Depreciation per year =$350,000/7

=$50,000 per year

NB//The equipment has no residue value while the building has already fully depreciated and hence it cannot be further depreciated.

Operating cashflows over the seven years period

Description

Cash inflows from sales

$3,000,000

$3,300,000

$3,465,000

$3,638,250

$3,820,160

$4,011,170

$4,211,730

Cost of sales

Inflation at 5%

Cost of sales

$1,800,000

$1,800,000

$1,980,000

$2,079,000

$2,070,900

$ 103,950

$2,182,950

$2,182,950

$ 109,150

$2,292,100

$2,292,100

$ 114,600

$2,406,700

$240,6700

$ 120,340

$2,527,040

$2,527,040

$ 126,350

$2,653,390

Fixed costs

$700,000

$800,000

$900,000

$1,000,000

$1,100,000

$1,200,000

$1,300,000

Depreciation

Pretax profit

$450,000

$371,000

$332,050

$296,150

$263,460

$234,130

$208,340

$135,000

$111,300

Profit after tax

$315,000

$259,700

$232,435

$207,305

$175,640

$163,891

$145,838

Terminal cashflows

Description

Cash inflows from sale of building

$900,000

Net present value

Description

Initial cashflows/Investment cashflows

-$1,112,000

Change in working capital

-$25,000

Cashflow from operations

$315,000

$259,700

$232,435

$207,305

$175,640

$163,891

$145,838

Terminal cashflows

$900,000

Net cashflows

-$1,142,000

$315,000

$259,700

$232,435

$207,305

$175,640

$163,891

$1,045,838

Discount factor @11.5%

0.896861

0.804360

0.721399

0.646994

0.580264

0.520416

0.466741

Present value

-$1,142,000

$282,511

$208,892

$167,678

$134,125

$101,918

$488,135

$326,550

  1. As can be seen from the above computation, the new project will have a positive net present value of $326,550. This means that it is a viable project as it will create value for the shareholders. As such, the company should accept the project and hence go ahead and implement it.

Sensitivity to inflation

  1. To address the CEOs concerns, I would conduct a simple sensitivity analysis on the costs using simple sensitivity analysis in a bid to determine the effect that an increase of inflation above 5% would have on the project’s profitability and hence the final net present value. In this regard, I would use a higher rate of inflation say 8% to rework the cost of goods sold and hence the effect this would have on the project’s profitability after tax and hence its net present value over the seven years period. If the NPV reduces to such an extent that it becomes negative, then I would advise that the company should be cautious when implementing the project with an aim of assuring itself that inflation will be at manageable levels. If the result reveals that a rise in inflation will not have a great effect on the project’s NPV, then I would advise the company to go on with the project (Jared, 2005). The following sensitivity analysis has been carried out using an inflation rate of 8% to demonstrate how I would determine the effect of inflation and hence be able to advice the company on whether to go on with the project or not.

Description

Cash inflows from sales

$3,000,000

$3,300,000

$3,465,000

$3,638,250

$3,820,160

$4,011,170

$4,211,730

Cost of sales

Inflation at 8%

Cost of sales

$1,800,000

$1,800,000

$1,980,000

$ 154,800

$2,134,800

$2,070,900

$ 165,672

$2,236,572

$2,182,950

$ 174,636

$2,357,586

$2,292,100

$ 183,368

$2,475,468

$2,406,700

$ 192,536

$2,599,236

$2,527,040

$ 202,163

$2,729,203

Fixed costs

$700,000

$800,000

$900,000

$1,000,000

$1,100,000

$1,200,000

$1,300,000

Depreciation

Pretax profit

$450,000

$315,200

$278.428

$230,664

$194,692

$161,934

$132,527

$135,000

Profit after tax

$315,000

$220,640

$194,900

$161,465

$136,284

$113,353

Net present value

Description

Initial cashflows/Investment cashflows

-$1,112,000

Change in working capital

-$25,000

Cashflow from operations

$315,000

$220,640

$194,900

$161,465

$136,284

$113,353

Terminal cashflows

$900,000

Net cashflows

-$1,142,000

$315,000

$220,640

$194,900

$161,465

$136,284

$113,353

$992,769

Discount factor @11.5%

0.896861

0.804360

0.721399

0.646994

0.580264

0.520416

0.466741

Present value

-$1,142,000

$282,511

$177,474

$140,601

$104,467

$164,491

As can be seen from the example above, the NPV significantly declines when the rate of inflation increases to 8%. As such, I would carry out such sensitivity analysis until I get a negative value of NPV. After this, I would perform interpolation in a bid to come up with the inflation rate at which the NPV would be zero. Thus, I would advise the company to ensure that as the project is implemented, the management has assured itself that inflation would not rise to such a level thus ensuring that the company does not run into losses on implementing the project.

Effect of product acceptance

  1. Description

Cash inflows from sales

$1,000,000

$1,100,000

$1,155,000

$1,212,750

$1,273,388

$1,337,057

$1,403,910

Cost of sales

Inflation at 8%

Cost of sales

$ 600,000

$ 600,000

$ 660,000

$ 693,000

$ 693,000

$ 727,650

$ 727,650

$764,033

$ 764,033

$ 802,235

$ 802,234

$ 842,346

$ 842,346

$ 884,463

Fixed costs

$700,000

$800,000

$900,000

$1,000,000

$1,100,000

$1,200,000

$1,300,000

Depreciation

Pretax profit

-$443,000

— $522,650

$601,283

-$678,847

$755,289

$830,553

Profit after tax

-$350,000

— $443,000

— $522,650

$601,283

-$678,847

$755,289

— $830,553

Net present value

Description

Initial cashflows/Investment cashflows

-$1,112,000

Change in working capital

-$25,000

Cashflow from operations

-$350,000

-$443,000

-$522,650

-$601,283

-$678,847

-$755,289

— $830,553

Terminal cashflows

$900,000

Net cashflows

-$1,142,000

-$350,000

$443,000

-$522,650

-$601,283

$678,847

$755,289

Discount factor @11.5%

0.896861

0.804360

0.721399

0.646994

0.580264

0.520416

0.466741

Present value

-$1,142,000

$313,901

$356,331

$338,151

-$389,086

$393,910

$393,064

-$3,294,029

If product acceptance is low with the unit sales dropping to 40,000 bottles per annum over the entire project horizon, the project would turn into a loss making venture with an NPV of $3,294,029. As such, it would be important for the company to first assure itself that the product have a high demand as was anticipated (of 120,000 bottles annually) so that it can be a profitable venture for the company and hence create value for the shareholders. Otherwise, the company ought to drop the project and invest the money it has in a better project as far as profitability is concerned.

Greater risk

Net present value

Description

Initial cashflows/Investment cashflows

-$1,112,000

Change in working capital

-$25,000

Cashflow from operations

$315,000

$259,700

$232,435

$207,305

$175,640

$163,891

$145,838

Terminal cashflows

$900,000

Net cashflows

-$1,142,000

$315,000

$259,700

$232,435

$207,305

$175,640

$163,891

$1,045,838

Discount factor @15.5%

0.865801

0.749611

0.649014

0.561917

0.486508

0.421219

0.364692

Present value

-$1,142,000

$272,727

$194,674

$150,854

$116,488

$381,408

$128,636

If the new project will carry a greater risk than the business’ existing overall risk and the cost of capital is increased by 4% as an add on for the higher project risk, its overall attractiveness will decline. This is evidenced with a lower project NPV of $128,636. This therefore would call for the company to consider investing the money it has in its existing businesses if there is market for the current products or at least in a project that is less risky in a bid to ensure that the company can create as much value for the shareholders as was anticipated at 11.5% discount rate. However, other factors such as availability of extra market ought to be considered before making such a decision.

Conclusion

As has been observed above, the project will create value for the shareholders at the existing conditions. As such, the CEO and the board should go on and implement the project. However, it is worth noting that the project’s profitability will decline should the rate of inflation increase in line with the CEOs fears as seen in the sensitivity analysis. As such, the company ought to conduct due diligence before implementing the project in a bid to assure itself that the rate of inflation remains low if the project is to remain profitable for the company as anticipated (Don, 2015). The anticipated demand for the new product should also remain high if the project is to be profitable for the company. Failing this, the project is likely to be a loss making venture for the company and thus should be avoided. Finally, it is important that the project’s level of risk remains as anticipated at 11.5%. Should it rise, then the company should contemplate on investing the money on a less risky project or in its existing businesses all other factors remaining constant.

References

Halil, S2011, Project evaluation under inflationary conditions, London, Rutledge.

Jared, B2005, Advanced investment appraisal, Sydney, Prentice Hall.

Don, D2015, Capital budgeting: Financial appraisal of investment projects, New York, Taylor & Francis.