Capital Budgeting And Company Analysis

Question 1: Capital Budgeting

Initech is in the process of evaluating two long term investment projects. A capital budgeting analysis was performed for both the proposals and the results are presented below. NPV analysis has been used for both the proposals project as this is the most common and useful technique of capital budgeting. NPV is the difference of the present value of all cash inflows and the cash outflows. NPV is the chosen method because it has many advantages like it considers the time value of money, it takes into consideration all the cash flows related to the project, it gives a fair estimate of the profits and the value which would be added to the company because of the project.

In this project, the company is considering whether it should expand into production of a part for new generation mobile devices as the company expects high growth in this sector for the next five years.

NPV = sum of present value of cash inflows – cash outflows

= $16, 76,580 – $8, 00,000

= $8, 76,580

IRR = 36%

Here we see that the NPV of the project is positive which means that the project will add value to the company to the extent of the value of NPV. Also the IRR of the project is more than the discount factor which means that it is more than the required rate of return by the company. Hence, it is recommended that the company should go ahead with its proposal of production of a part for the new generation mobile devices.

Under this project, the company needs to install a new conveyer system as soon as possible because the existing system is beyond repair. The company has three options to choose from. The options are System A, System B and System C. Again a NPV analysis has been performed to give recommendation as to which option must be chosen.

Since all the systems only involve cash outflows, tax benefit on the cash outflows has been taken into consideration.

The table of cash flows for the three systems is presented below:

Here we will select the system which has the lowest NPV because there are all cash outflows. Hence, System B is the most profitable as it has the lowest NPV and hence would require minimum cash outflows.

a) An average risk capital investment project by Mantra group could be getting the management Letting Rights (MLR) to operate a property owned by someone else. The capital investment required for such an arrangement would be the up gradation of the apartment which the company wishes to get the rights for. A hypothetical investment of $10 million would be required which would include apartment up gradation costs and an increase in working capital required for operations. It is expected, the project would continue for 5-8 years after which the company will hand over the property to the owner. The cash inflows would be in the form of rent from room occupied by the customers. The cash outflows would be in the form of rent paid to the owner, salaries paid to the employees, the expenses relating to restaurant expenses, cleaning and laundry, sales and marketing costs.

The device part project

The most sensitive factor to the NPV would be the number of rooms occupied. If the rooms occupied are less than the anticipated, it would lead to losses because the company would have many fixed operating costs like rent and salary. Also WACC would be a sensitive factor. The company could take its current WACC as the cost of capital as the project relates to the current company business.

b) Working capital management is the firm’s ability to meet its short term obligations i.e. pay for its current liabilities with its current assets. An efficient working capital management ensures that a company uses its current assets like cash, inventories and receivables to pay for its liabilities like short term debt and payables.

The working capital management of Mantra Group Ltd. was analysed. In order to do so, cash conversion cycle was worked upon to see how well the company is managing its working capital.

Cash conversion cycle = Days inventory outstanding + days sales outstanding – days payables outstanding

On the basis of the annual report of the company for the years 2015 and 2016, the cash conversion cycle has been calculated as follows:

From the above table, we see that the cash conversion cycle is almost similar for both the years 2015 and 2016. This means the company takes on an average 18 days to convert its investment in inventory into cash. The company’s day’s inventory outstanding is very low at 2 days which means the inventory is fast moving. Inventory for the company is in the form of rooms, linen, cutlery etc. The company’s days sales outstanding is more than the days payables outstanding which means it pays its suppliers faster than it receives payment from its debtors. This has led to an increase in the conversion cycle.

However, if we compare the cycle to a competitor which is InterContinental Hotels Group which had a cash conversion cycle of 23 in 2016 (gurufocus, 2017), we see that Mantra group has a better management of working capital as it has a lower cash conversion cycle. InterContinental has very high day’s sales outstanding at 76 days. Hence, we can say Mantra has a good working capital management where inventory is fast moving, thus enabling free funds to meet in business expenses and also reasonable funds locked in receivables most of which is offset by outstanding payables.

a) Commercial papers are unsecured promissory note which are issued at a discount and are repaid at their face value on a specified date. They are used by corporations to finance their short term needs like working capital as they are cheaper than bank loans. Since commercial papers do not give high returns and are risky (as they are unsecured), they are normally issued by companies having a good credit rating (Gustke, 2011)

Hence, it can be said that Telstra has a low credit risk which is why it is able to finance its working capital with the issuance of commercial paper.

b) Telstra is using matching the maturities principle to finance its current assets i.e. it is using short term finance. It means the company is using short term finance to finance its short term assets or current assets. Alternatively the company may use long term finance like long term debt to finance its current assets but it is disadvantageous because the interest rate would be high and the risk exposure would also be high (Citeman, 2008)

Advantages of short term financing include low cost, convenient, flexibility in terms of obtaining finance as and when needed, easily available, no control of lenders in the business. All the above advantages are not there in long term financing.

Reference

Gurufocus, (2017), InterContinental Hotels Group PLC (NYSE:IHG), Cash Conversion Cycle, accessed online on 27^th April, 2017, available at https://www.gurufocus.com/term/CCC/IHG/Cash-Conversion-Cycle-CCC/InterContinental-Hotels-Group-PLC

Gustke, C., (2011), Commercial Paper: More Risk, Less Return, accessed online on 27^th April, 2017, available at, https://www.bankrate.com/investing/commercial-paper-more-risk-less-return/

Citeman, (2008), Current Assets Financing Policy, accessed online on 28^th April, 2017, available at https://www.citeman.com/3679-current-assets-financing-policy.html

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