Capital Budgeting Analysis For Equator Ltd’s Tablet Computer Manufacturing Expansion

Option 1: Plant A – Highly Automated Process

Questions:

1.Calculate the NPV, Non-Discounted Payback, and the IRR of Plant A and Plant B.  Interpret your results. (If relevant, state any assumptions you have made.)

2.Describe and Analyse 4 keys risks associated with the Project you recommend (Project A or B).
                                                   

3.Briefly define an ‘Efficient’ Capital Market.  To what extent is Equator’s ability to borrow funds in the Capital Market dependent upon the Capital Market Operating in an Efficient Manner? 

1.Equator Ltd, an Australian manufacturer of laptop computers, is considering expanding its Australian operation into producing tablet computers. For this expansion the CFO has two options. The first option, Plant A, is a highly automated process that involves significant capital outlays but has lower running costs. Plant B is a more labour intensive facility that has lower initial capital outlays but higher running costs. Plant A and Plant B are mutually exclusive projects. A capital budgeting analysis of both the options was carried out to decide which project the company must choose to manufacture the tablet computers.

The incremental cash flow for both the projects is presented below:

NPV = sum of present value of all cash flows

            = $25,671,833

IRR = 20% (using the excel formula)

Payback period

Payback period = 3+(-$2,76,09,210.8 / $3,95,96,894.8)

                         = 3.7 years

Working Notes

1.

 2.

 The incremental cash flow for project B is presented below:

NPV = $1, 18, 89,346.5

IRR = 18% (using the excel formula)

Payback period

Payback period = 3+ (-$1,23,36,640.2 / $3,10,20,914.5)

                          = 3.4 years

Working Notes
1.

2.

3.

The result of the analysis is given below:

Plant A has a higher NPV and IRR while plant B has a better payback period. However, we will consider Plant A and decide on choosing Plant A for manufacturing the tablet computers because for mutually exclusive projects, the project with a higher NPV should be preferred over all other capital budgeting techniques. This is NPV is considered the best technique as it takes into account the time value of money unlike IRR and non discounted payback period. Also NPV considers all the future cash flows of the project unlike payback period. NPV is the excess of cash inflows over the cash outflows. Hence, higher the NPV, higher is the profitability of the project. Therefore the company should set up Plant A which is highly automated as it has a higher NPV.

There were certain assumptions which were made while doing the analysis. The discount rate considered for discounting the future cash flows is the WACC used by the Computer Tablet industry. This is because the discount factor should be such that it incorporates the risk of the project, and since this project is related to the Computer Tablet industry, hence, it is better to take WACC of industry instead of the WACC of the company. The working capital is assumed to be recovered at the end of life of the project. The head office expenses have not been considered in the analysis because it is not an incremental expense and does not arise as a result of the project.

Option 2: Plant B – More Labour-Intensive Facility

2.Capital budgeting is based on the estimation of the various inflows and outflows related to the project. The management of the company expects the project to deliver the required benefits in order to be profitable. The various types of risks that may be associated with the Project A (recommended) are discussed below:

1. a) Stand alone risk – this risk pertains only to the project in question and does not affect the other assets of the company. The risk is associated with the estimation of the future inflows outflows and is quantified by the amount of deviation of the actual inflows and outflows to the estimated one (Burja1, Burja2, 2009)
2. b) Company risk – the project is part of the company and hence it also poses risk for the company as a whole as to how the earnings of the company will be affected as a result of undertaking the project. Also the risk of the project may be diversified by the company’s other assets.
3. c) Market risk – this risk is associated with the market conditions of the economy. The future estimations are based on the overall economic growth and the inflation rate, as given in this case also, so there is a risk that the economic conditions may change and as such all the estimations may go wrong resulting in negative effects for the project. Market risk also includes the change in demand of the tablet computers. The estimations are based on the current market scenario, however if the demand changes, risk of project failure increases.
4. d) Industry specific risk – this involves the legal and technological risk of the industry. Under legal risk, there might be a change in the government policies for the industry which may affect the company’s earnings. Also a technological advancement may render the tablet computers outdated which would decrease its market demand.

3.Efficient capital market is a market where the prices of a security reflect the new information accurately and that too in real time. A market is said to be efficient if the share prices can fully incorporate and induct the information which includes the basic value of the share. The value of the share is the present value of all the future cash flows associated with the share. The cash flows are in the form of dividends and the selling price of the share in the end. Such efficient markets are said to exist in the real world due to the capital markets being more and more organized and with the transaction costs being very low and information being easily available to all participants, the markets are said to be efficient. The efficient market hypothesis assumes that no analyst or trader can profits from trading as the trading will push the prices of the shares to its real value and thus the shares will be accurately priced. Three forms of efficiency in capital markets are said to exist which are weak form efficiency in which assumes that all the past activities and information of the stock is incorporated into its price and hence technical analysis is useless in this market form. Under semi strong form, the stock prices are assumed to reflect all publicly available information accurately. However, there exists scope for making abnormal gains by accessing private information available to the insiders of the company. Under strong form, the share prices reflect all information whether public or private and neither technical nor fundamental analysis is useful in this market form. The importance of efficiency of capital markets lies in two ways. First, if the investors can make excess profits by applying trading strategies and second if the stock price reflects all information accurately, the new capital goes to the investment which has it highest valued use (Jones, Netter, NA)

Capital markets are used to raise funds by government for infrastructure projects and by private firms for growth and expansion (Marwa, 2016). The primary role of a capital market is allocation of the ownership of the capital stock of the economy. Therefore a capital market allows the firms to make investment decisions and the investors can choose from the various stocks available in the market which represent the firms activities. Also the investors assume that the prices of the stock fully reflect the available information (Fama, 2010). The shareholders of a company want the company’s management to maximize the stock prices and thus will ensure the company invest in high valued investments which will increase the shareholder return. Thus if the stock market is efficient, the company can emphasize on investing in long term projects as the funds are easily available and also the prices of new share at which the investors are willing to invest are determine by the market and reflects the value of the future cash flows of the project. Moreover, a company whose stocks have appreciated finds it easier to raise funds in a capital market because higher share prices means a small ownership of the company needs to be given to raise capital. Favourable economic conditions also make it easier to raise funds. Since the tablets computer industry is a hot industry, thus it will be easier for Equator Ltd. to raise funds in the capital market and that too at the correct prices.

References:

Burja1, C., Burja2, V., (2009), The Risk Analysis for Investments Projects Decision, Annales Universitatis Apulens Series Oeconomica, Vol.11, No.1

Fama, E.F., (2010), Efficient Capital Markets: A review of Theory and Empirical Work, The Journal of Finance, Vol.25, N0.2

Marwa, M., (2016), Market Data Review: The Role of Capital Markets in Financing Development, accessed online on 13^th Feb, 2016, available at https://www.thecitizen.co.tz/News/Business/The-role-of-capital-markets-in-financing-development/1840414-3445302-vd9vvi/index.html

Jones, S.L, Netter, J.M., (NA), Efficient Capital Markets, accessed online on 13^th February, 2017, available at, https://www.econlib.org/library/Enc/EfficientCapitalMarkets.html                       

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